CFM 302. Monetray Theory Policy

CFM 302: MONETARY THEORY AND POLICY
CFM 302: MONETARY THEORY & POLICY
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BUSS 101/CFU 102 : INTRODUCTION TO MICRO-ECONOMICS
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MODULE TITLE: CFM 302-F MONETARY THEORY AND POLICY

Introduction
The Introduction to Monetary theory module deals with the theoretical and practical
framework of the economy.It is a descriptive economic theory that details the procedures
and consequences of using government-issued tokens as the unit of money, i.e., fiat
money. According to Modern Monetary Theory, "governments with the power to issue
their own currency are always solvent, and can afford to buy anything for sale in their
domestic unit of account even though they may face inflationary and political
constraints".
Monetary Theory and policy aims to describe and analyze modern economies in which
the national currency is fiat money, established and created exclusively by the
government. In Monetary Theory and Policy, money enters circulation through
government spending. Taxation and its Legal Tender power to discharge debt establish
the fiat money as currency, giving it value by creating demand for it in the form of a
private tax obligation that must be met using the government's currency. An ongoing tax
obligation, in concert with private confidence and acceptance of the currency, maintains
its value. Because the government can issue its own currency at will, Monetary Policy
maintains that the level of taxation relative to government spending (the government's
deficit spending or budget surplus) is in reality a policy tool that regulates inflation and
unemployment, and not a means of funding the government's activities per se.
The first part of this writing introduces students to the evolution of money. Students
should be able to understand the need for and supply of money in the economic system.
Secondly having obtained the theoretical background of monetary policy, students will be
introduced to the fluctuations in the value of money with specific reference to the Kenyan
situation. Students should be aware that there are changes in the value of money
depending on the economic situations in the country. Thirdly the students will be
introduced to the quantity theory of money which covers the Fishers approach,
Cambridge and Income theory and investment approach Lastly, general monetary policy
for developing nations and theories of interests will be examined in detail. At the end of
each topic, there are self-test questions and activities to enable you understand the topic
further.
Objectives
By the end of this unit you should be able to;
Explain the scope and rationale of monetary theory and policy
Describe the demand for and supply of money in an economy
Differentiate between the theories of money
Identify the need for interest
Advice on the suitable monetary tools and techniques for a developing economy.
Contents
1.0 LECTURE ONE: INTRODUCTION TO MONETARY POLICY............................3
1.1.1
Introduction.......................................................................................................3
1.1.2
Specific objectives.........................................................................3
1.1.3
Evolution of money...........................................................................................4
1.1.4
Functions of money...........................................................................................5
1.1.5
Qualities of a good money................................................................................6
1.1.6
Role of money in different economic systems..................................................8
1.1.7
Lecture activities...............................................................................................8
1.1.8
Self-test questions.............................................................................................9
1.1.9
Summary of the lesson.....................................................................................9
1.1.10 Further Readings..............................................................................................9

2.0 LECTURE TWO : DEMAND FOR AND SUPPLY OF MONEY...............................10
2.2.1
Introduction....................................................................................................10
2.2.2
Specific Objectives.........................................................................................10
2.2.3
Demand for Money........................................................................................11
2.2.4
Transactional Demand for money..................................................................12

2.2.5
Keynesian approach to the Demand for money............................15
2.2.6
Supply of Money .........................................................................16
2.2.7
Components of Money supply.......................................................18
2.2.8
Items excluded in the money supply..............................................18
2.2.9
Determinants of money supply......................................................20
2.2.10 Lecture activities............................................................................23

2.2.11 Self-test questions..........................................................................23
2.2.12 Summary........................................................................................23
2.2.13 Suggestions for further reading......................................................23
3.0 LECTURE THREE : THEORY OF MONEY AND PRICES................................. 25
3.3.1 Introduction ....................................................................................25
3.3.2 Specific objectives...........................................................................26
3.3.3 Quantity theory of money...............................................................26
3.3.4 Transaction approach.....................................................................27
3.3.5 Fishers equation of exchange.........................................................27
3.3.5 Assumptions of the Fishers theory.................................................30
3.3.6 Criticism of the Quantity theory of money...................................31
3.3.7 Lecture activities..........................................................................33
3.3.8 Self-test questions........................................................................34
3.3.9 Summary.....................................................................................34
3.3.10 further readings..........................................................................34
4.0 LECTURE FOUR: CASH BALANCE APPROACH TO THE QUANTITY
THEORY OF MONEY............................................................................................35
4.4.1 Introduction ..................................................................................36
4.4.2 Specific objectives.........................................................................36
4.4.3 Equations of the Cash Balance Approach......................................38
.4.4 Criticism of the Cash Balance Approach...........................................40
4.4.5 Comparison of Fishers Approach with the Cambridge Approach..40
4.4.6 Lecture Activities...........................................................................44
4.4.7 Self-Test questions.........................................................................44
4.4.8 Summary.........................................................................................45
4.4.9 Further readings............................................................................45
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5.0 LECTURE FIVE : KEYNESIAN VIEWPOINT ON THE QUANTITY THEORY OF

MONEY ..................................................................................................................46
5.5.1 Introduction ....................................................................................46
5.5.2 Specific Objectives..........................................................................46
5.5.3 Motives why people hold wealth as money rather than as interest
bearing securities........................................................................................47
5.5.4 Total demand for money...................................................................52
5.5.5 Keynesian view on interest rates and money supply and
demand.......................................................................................................53
5.5.6 Effects of an increase in the supply in the Keynesian view
point..........................................................................................................54
5.5.7 The Monetarists view point.............................................................55
5.5.8 Limitations of the Monetarist..........................................................56
5.5.9 Implications of the Keynesian and Monetarist theories for economic
policy..........................................................................................................57
6.0 LECTURE SIX: INCOME THEORY OR SAVING INVESTMENT.......................60
6.6.1 Introduction.........................................................................................58
6.6.2 Specific Objectives..............................................................................59
6.6.3 Explanation of the Theory..................................................................60
6.6.4 Importance of the Saving Investment Theory....................................62
6.6.5 Learning Activity...............................................................................63
6.6.6 Self Test Questions............................................................................64
6.6.7 Summary.............................................................................................64
6.6.8 Suggestions for further reading...........................................................64
7.0 LECTURE SEVEN: MILTON FRIEDMANS VERSION TO THE QUANTITY
THEORY OF MONEY................................................................................................66
7.7.1Introduction.................................................................................... 66
7.7.2Specific objectives.............................................................................67
7.7.3 Determinants of demand for money................................................68
7.7.4 Wealth holders demand for money................................................69
7.7.5 Demand for money by business firms.............................................69
7.7.6 Conclussins......................................................................................70
7.7.7 Lecture activity................................................................................70
7.7.8 Self test questions............................................................................71
7.7.9 Summary .........................................................................................71
7.7.10 Suggestions for further reading......................................................71
LECTURE EIGHT: MONETARY POLICY................................................................72
8.8.1 Introduction.....................................................................................72
8.8.2 Specific objectives...........................................................................73
8.8.3 Objectives of monetary policy.........................................................74
8.8.4 Instruments of monetary policy........................................................76
8.8.5 Limitations of Monetary Policy.......................................................77
8.8.6 Lecture activity................................................................................78
8.8.7 Self-test questions............................................................................78
8.8.8 Summary .........................................................................................78
8.8.9 Suggestion on further reading..........................................................78
LECTURE NINE: FLUCTUATIONS IN THE VALUE OF MONEY.........................79
9.9.1 Introduction......................................................................................79
9.9.2 Specific objectives............................................................................80
9.9.3 Inflations and its different Forms.....................................................81
9.9.4 Inflationary Gap...............................................................................84
9.9.5 Wiping out Inflationary Gap............................................................88
9.9.6 Causes and effects of inflation..........................................................89
9.9.7 Measures to control Inflation............................................................97
9.9.8 Deflation.........................................................................................100
9.9.9 Causes.............................................................................................101
9.9.10 Effects of deflation.......................................................................103
9.9.11 Measures to check deflation..........................................................105
9.9.12 Lecture activities...........................................................................106
9.9.13 Self-test questions.........................................................................106
9.9.14 Summary.......................................................................................107
9.9.15 Suggestion for further reading......................................................107
LECTURE TEN THEORIES OF INTEREST...............................................................114
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10.10.1 Intriductiobn...............................................................................114
10.10.2 Specific objectives......................................................................114
10.10.3 Theories of interest.....................................................................114
10.10.4 Determination of interest rates....................................................117
10.10.5 Lecture activity...........................................................................125
10.10.6 Self-test questions.......................................................................125
10.10.7 Summary.....................................................................................125
10.10.8 Suggestion for further reading....................................................126
LECTURE ELEVEN: CREDIT CREATION AND CONTROL...................................127
11.11.1 Introduction................................................................................127
11.11.2 Specific Objectives.....................................................................127
11.11.3 Quantitative methods of credit control......................................128
11.11.4 Qualitative methods of credit control........................................134
11.11.5 Learning activity........................................................................139
11.11.6 Self-test questions......................................................................140
11.11.7 Summary....................................................................................140
11.11.8 Suggestion for further reading...................................................140
LECTURE TWELVE: BANKING SYSTEM..............................................................141
12.12.1 Introduction...............................................................................141
12.12.2 Specific objectives.....................................................................142
12.12.3 Central Bank..............................................................................143
12.12.4 Central bank changing role........................................................144
12.12.5 Money and Capital market........................................................144
12.12.6 Financial intermediaries.............................................................145
12.12.7 Commercial Banks and its Functions........................................145
12.12.8 Role of non-banking financial institutions.................................147
12.12.9 Lecture activity..........................................................................147
12.12.10 Self-test questions....................................................................147
12.12.11 Summary..................................................................................148
12.12.12 Suggestion for further reading................................................148
1.0 LECTURE 1: INTRODUCTION TO MONETARY THEORY AND POLICY
1.0 Introduction
Welcome to the first Lecture of Introduction to Monetary theory and Policy. This lecture
covers definition of money, evolution of money, features or qualities of good money,
functions of money and money in different economic systems. We will start by defining
what money is and what to be considered as money.
1.1.1 Specific Objectives

At the end of the lesson you should be able to;
Define the term money.
Explain the various evolutionary stages of money.
Identify the qualities of a good money
Outline the role of money in different economic systems
1.1 Lecture Outline

1.1.1 Definition of money
1.1.2 Evolution of money
1.1.3 Functions of money
1.1.4 Features of a good money
1.1.5 Role of money in different economic system
1.1.1 Definition of money
Money is a commodity which is universally accepted in exchange of all other
commodities with no intention on the part of the receiver of using it in part of the
received of using it in any other way than to effect further exchanges. Thus money is a
commodity that facilitates exchange of commodities.
medium of exchange: a medium of exchange issued by a government or other public
authority in the form of coins of gold, silver, or other metal, or paper bills, used as the
measure of the value of goods and services
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1.1.2 Evolution of money

1. Commodity Money
In barter trade commodities were exchanged for commodities e.g. one goat for a
sack of maize. With time certain commodities were identified by communities
and used as medium of exchange e.g. beads, hides and skins, tobacco, cowrie
shell etc. Those identified commodities functioned as basic money. To serve as
money the conditions needed to be easily verifiable, transportable and divisible
and also easy to store.
2. Metallic Money(Real Money)
Commodity money posed the challenge of being bulky and inconvenient, unstable
in value and some were perishable and so could no longer serve as standardized
medium of exchange. The communities identified metals such as bronze, copper,
silver and gold to act as money. These came to be known as metallic money. The
metals were not easily available
Coins minted were full bodied. The monetary value of the metal was equivalent
to the commercial value of the material it is made of (had intrinsic value)
3. Coinage Money
As trade developed, metallic money became more refined as metals were minted
in appropriate sizes and quantities of coins to act as standard medium of
exchange.
Coins are portable, divisible, durable, mintable and their value does
not fluctuate considerably. Owing to high demand metals become rare to obtain.
Their weight of value was guaranteed by competent authority.
4. Paper Money
The receipts given out by goldsmiths to merchants and other who deposited gold
and other metals for safe custody, acted as paper money. The holder of such
receipts (that acted as I OWE YOU (IOU) would make payment by signing the
receipts at the back. The holder would present the receipts to a goldsmith if he
wanted the gold. These receipts became bank notes with time as people showed
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confidence in them. As 1st time bank notes/receipts were not considered as

money but acted simply as an acknowledgement of a bankers debt (IOU). As
time went by paper money became popular as more and more people were willing
to accept it even it could not be converted into gold or silver. This is the origin of
the banking principle as applied today. Paper money is referred as legal tender
(currency notes and coins that are accepted for their printed face value because of
the law)
5. Representative Money(Credit money)
(Legal tender refers to currency notes and coins that are accepted for their printed
face value because of the law).
The legal tender is inconvenient and ..to use where large transactions
are involved. This led to the development of other forms of paper that perform
the functions of currency money (represent currency money held elsewhere e.g.
cheques, promissory notes, credit cards etc.
Evolution of money (diagrammatically)
Barter
Commodity
Metallic
Coinage
Paper
Credit Money
1.1.3. Functions of Money

1. Medium of Exchange: Individuals sell their goods for money and later on
they use this money to buy some other goods. It allows the seller to sell goods
in unfinished state and the buyer to make factional purchases.
2. Money as a Unit of Account: The monetary unit of account is used to
measure the value of foods and services in the economy, added and accounts
kept. Money is thus the yardstick that allows the individuals to measure the
relative value of goods and services. The issue of money as unit of account
has greatly reduced transaction costs to the time effort and expenses that go
into the purchase or sale of goods.
3. Measure of value: The prices of different goods are indicated in terms of
money. It is easy to compare the relative values of commodities which are

12
dissimilar and entirely different from one another.
The values are in
proportion to their respective prices.

4. Store of value: Money enables one to keep portion of his assets liquid to be
used as and when the need arises. An individual can save some part of their
income during young age and use it during old age. Thus money helps
individuals to keep some money reserves for future transactions.
5. Standard of Deferred Payments: Money is used to make future credit
transactions. It makes borrowing and lending less risky by acting as standard

measure of payments overtime.
6. Transferring immovable Property: An owner of a house, for instance can sell
the house in one geographical location and buy another house in another
location, thus transferring the value of the house through immovable.
1.1.4 Qualities/properties /characteristics of good money

To adequately perform the above functions money must possess the following qualities:
1. Scarcity: Money need not have any intrinsic value (useful as a commodity but it
must be scarce. That is to acquire money there is some opportunity cost. The
scarcity of money contributes to the stability of the value of money.
2. Stability of value: Money should be stable in value for it to be used as standard to
measure the value of all other commodities.
3. Durability: For money to act as store of value it must last for a long time i.e.
should not die, wither away or be easily defaced.
4. Portability: Money should be easily transportable from one place to another
without depreciation. It should have a large value in small bulk so that is it
convenient to carry.
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5. Homogeneity: For money to act as unit of account different units of money

material should have the same value. The material should be having informed
quality and capable of standardization.
6. Acceptability: For money to act as a medium of exchange (in exchange of all
goods and services) it must be acceptable to all without hesitation.
7. Divisibility: Money must be divisible into small units, to enable people undertake
all types of transactions, without loss in its value.
8. Cognoscibility: Money should be easily recognized by those using it to effect
exchanges.
9. Malleability: Money should be capable of being moulded into given/required
shapes and be stamped.
1.1.5 Role of money in different economic systems
Capitalist economy
The capitalist economy recognizes the right of individual property. It is free from all
government control. All factors of production are controlled, owned, and operated by
private entrepreneurs. The owner of the property in a capitalistic economy can use his
property, according to his own choice. The price is naturally guided by the price
mechanism i.e. before taking up any economic activity, a businessman or an
individualist it considers the cost, prices and the rate of profit. He therefore engages
in various productions which may produce good return. Thus profit motive is the
prime factor in capitalistic economy. Capitalistic cannot function without price
mechanism and price mechanism cannot function without money. Thus money is the
life blood of capitalistic economy, hence;
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Consumer can make a rational choice of goods.
Production decisions are based on money
Money simplifies the distribution system
Decision regarding saving and spending
Price mechanism regulates the flow of investment
Money is the basis of credit
Socialistic economy
All economic activities are planned, controlled and guided by the government or its
agencies. No free market and no right of property to individuals.
Q1, Do you think money has any role to play in economy?(Marx believed that money is
the root cause of exploitation of labour by the capitalists, socialist can work without
money i.e. goods exchanged for goods)Leon Trotsky in 1921 realized that without a firm
monetary unit, commercial accounting only increases chaos All commercial
transactions are carried on in money though money occupies an inferior and subordinate
position in the economy. Even in a socialist economy cannot work without money. Hence
money;
Is a guide to economic activities
Allocation of resources
Distribution of income
Planned Economy
A planned economy is generally followed in underdeveloped countries where there is no
shortage of real / natural resources. The need is only to tap those resources in a planned
manner. The state takes the responsibility for the development of these dormant resources
through agencies or private enterprises but under the guidance of the government. The
development of the economy needs or tapping of natural resources needs monetary
resources whish are in plenty and the government has to provide to activate the real
resources
The government of such a country taps all the possible sources of monetary resources to
carry out development plans. For this purpose the government collects money through
taxes, borrowings from inland and foreign sources and deficit financing. The government
in a planned economy therefore controls the imports and exports and internal transactions
to keep a balance in the economy. Thus money plays important role in a planned
economy.
15
1.1.6 Lecture Activities

Explain the evolution process of money
Identify the core qualities of a good money
Discuss why barter trade still exist in some parts of the country?
1.1.7 Self Test Questions

Describe the challenges experienced during the commodity money
Why do you think that money is seen as a pivot on which the economic science
clusters?
Explain why money is considered to be more important in a capitalist than a

socialist economy?
1.1.8 Summary
In this lesson we have learnt that:
Money is any commodity that is generally accepted as a means of settling
payment
Money evolved into five different stages namely; commodity, metallic, coinage,
paper and representative money respectively
Money can move immovable property
Money must be scarce for it to perform its medium of exchange function

effectively
Economic systems use money to produce, allocate and distribute national

resources, above all money rules in a capitalist economy.
1.1.9 Suggestion for Further Reading

The student can read further on different kinds of money available to a modern economy
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2.0 LECTURE TWO: DEMAND FOR MONEY SUPPLY OF MONEY
2.1 Introduction
Welcome to the second lecture of this unit. This chapter follows up on what we looked at
in the previous lecture. In the previous lecture, we saw that the core function of money is
its medium of exchange, money can be used as a store of wealth and a mode of settling
future transactions as mentioned earlier. If the above must be achieved, there is need to
have money. The demand for money is summarised below. Thereafter we will look at the
supply of money.
2.1.1 Specicific Objectives

At the end of this lecture the student should be able;
State briefly the demand for money
Explain the determinants of transactional demand for money
Give reasons why demand for money is insatiable
List components of money supply
Describe the determinants of money supply
2.2 Lecture Outline

2.2.1 Demand for money
2.2.2 Determinants of transactional demand for money
2.2.3 Keynesian approach to the demand for money
2.2.4 Supply of money
2.2.5 Components of money supply
2.2.6 Items excluded in the supply of money
2.2.7 Determinants of money supply
17
2.2.1 Demand for money

Introduction
Demand for money is basically different from the demand of commodities and services.
Demand for commodities is made because they have utility i.e. quality of satisfying the
needs of people. But money does not possess utility to satisfy consumers directly. Why is
money demanded?
Demand for money is made for two reasons;
1. It serves as a medium of exchange
2. It works as a store of value
As a medium of exchange, money help in the exchange of other goods and services and
acting as a store of value, it is held as an asset.
The former gives rise to the transaction demand for money while the latter gives rise to
the asset demand for money. The aggregate demand for money is the sum of these two
separate demands.
The supply of money or the volume of money in circulation refers to the volume of
money held by the public i.e. individuals PR business firms in the form of coins and
currency notes and deposits with the banks withdrawals by cheques. But it does not
include currency held by the central bank, the government and the commercial banks
The demand and supply of money determines the level of income, expenditure, savings,
investment, prices etc. in the economy.
Money problems of the economy are closely associated with and have remedies in
regulating the demand for supply of money.
2.2.2 Transactional Demand for money.

Demand for money is made to facilitate the trading activities i.e. purchases and sale
because in modern economy goods and services are purchased with some unit of
currency. it is therefore necessary for individuals and business firms to hold at least as
much money as required to meet their forthcoming expenditure. The cash balances held
by individuals and firms
on hands for this purpose are called transaction balances
When the quantity of money held by all individuals and business firms is added up for the
18
purpose of financing their forthcoming expenditure, then it is called transactional

expenditure
The need to hold money for transaction balances arises form the fact that the receipts and
payments do not occur simultaneously. They are never synchronized for both individuals
and firms, the fact is that the income is not wholly spent instantaneously but is kept to
meet the needs in future till the period, the income again is to be received ( the balance of
income will continue to smaller and smaller until it approaches zero or near zero by the
end of the month ) for business firms the receipts and payments will be spread over the
entire month. Thus the, it is luck of synchronization between money flows and money out
flows that compel them to hold money in cash for meeting day to day requirement. It
gives rise to transaction demand for money.
2.2.3 Determinants for transaction demand
1. Level of Income
The level of income determines the size of the transactions balances demanded. The
higher the level of income, the larger would be size of money holdings for transaction
purposes. The money holding for transaction purpose is the function of the level of
income.
MT = K.Y
Where MT = Money holding for transaction purpose
K= Proportion of level of income
Y= Level of national income
If the level of income (Y) is kshs. 1000, K is 1/5, the demand for transaction
purpose (MT) would be Kshs. 200
Or
MT= 1/5X1000
Or
Kshs. 200
If the national income changes, MT would change accordingly in the same proportion as
K is assumed ton be constant. If the National Income goes up to Kshs. 1500, the demand
for transaction purpose would be 1/5 Kshs. 1500 i.e kshs. 300. The change in MT would
create or reduce the demand for money for transaction purpose in the economy.
2. Pattern of Income Payments and Expenditure
19
The time lag between the receipt of income and payments is also important and influence
the demand for money. The larger the interval of income payments in an economy, the
larger the demand for carrying out transactions. An income of kshs. 1,200 yearly would
require on each per day kshs. 10,000 if paid yearly, Kshs. 1,000 if paid monthly and
Kshs.250 if paid weekly, hence larger money would be required if people spend their
income evenly over the income period than if they spend the income in a part of the
period of time.
3. System of payment
The system of income payments includes two factors;
a. Stages in transactions, and
b. Pattern of flow of payments
Stages in transactions
The system of payment also influences the volume of transactions and the demand for
money. Money passes through distinct stages viz. from income recipient to retailers and
then through a number of agencies to producers and again to recipients as factor
payments. The actual number which varies from economy to economy determines the
volume of transactions. The larger the number of stages in an economy, the greater the
volume of transactions and larger the demand for money.
Pattern of flow of payments
If the flow is regular and even, the smaller amount would be required for transactions.
Regular means payment from one stage to next stage is only when it is received from the
earlier one. If the flow is uneven or it is made even before payments are received from
earlier stage, the money requirement for transaction purpose would be greater.
4. Use of credit
This reduces the effective demand for money for transaction purposes. A given volume of
transaction would be possible to be carried out then. The use of credit postpones the
immediate requirement of money to pay of transactions. If credit is extended by a number
of parties to one another, it would be possible that a number of transactions would
council out and the final settlement may require a smaller amount the aggregate value of
all transactions. Thus credit economizes the use of money and wide prevalence of the
system reduces the demand for money.
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2.2.4 Keynesian Approach to the Demand for Money

One of the main functions of money is to serve as a store of value. The function gives
rise to the asset demand for money. The asset demand for money at a particular time
refer to the demand of individuals, business firms and the government for money to be
kept as cash balance as distinct from other assets. Money is an asset and is kept in the
form of cash balances. Being the most liquid asset it can serve as the store of value,
therefore it is demanded for its own sake and for purchasing goods and services to meet
out the needs of people. People want money to keep it in the form of cash balance
because, it has liquidity value.
2.2.5 Factors affecting asset demand for Money (Keynesian approach)
Money has the distinctive feature of being the only asset which is perfectly liquid.
Keeping it in the form of cash earns nothing.
Prof. Keynes has described three motives for holding money in the form of cash balances.
These are:
(a)
(a)
the transactions motive
(b)
the precautionary motive
(c)
the speculative motive
The transactions motive The money needs for the current transactions by the
individuals and business firms because of its medium of exchange function.
Keynes determines this motive by the level of income
(b)
Precautionary Motive or Demand The second motive for holding cash

balances by individuals, and business firms is to meet the requirements arising
out of any unforeseen or contingent incidents.
Future is uncertain and
therefore individuals and business firms may need money for contingent
payments or expenditures mainly arising out of events of quite uncertain nature
like accidents, prolonged illness, or loss of job or replacement of a productive
asset destroyed or damaged by accident, etc. Any cash balances kept to meet such
contingencies, are known as precautionary balances. Such demand of money for
precautionary balances is also closely related to the level of income. The higher
the level of income, the more shall be the cash balances for contingencies.
21
(c)
Speculation Demand Money also serves as a store of value which gives rise to
the asset demand of money. The speculative demand as referred to by Keynes is
the desire of the holder to keep cash balance as an alternative to the financial asset
like bonds. Keynes considered only two types of money cash and bonds.
People hold money in expectation of changes in interest rates or the capital value
of assets (bonds).
If people anticipate an increase in the prices of bonds, they would like to purchase bonds
at the current prices. If their anticipation proves correct i.e. the prices of bonds register
an increase, they will make capital gains of the transactions. Similarly, if they anticipate
a fall in the prices of bonds, they will prefer to sell them to avoid further losses. Thus
people convert their cash balances into bonds if prices of bonds are low and are expected
to rise and bonds into cash balance, if prices of bonds are high and are likely to fall.
Interest Rates and bond prices. A bond is a fixed-income bearing security which
brings in a fixed interest income on its face value. If bonds are purchased at par, the
income would be at the rate what has been ascribed on the face of it. As the bond
fluctuates in the market, the net income (yield) would be at a lower rate if bonds are
purchased at a higher market price (above par) or the yield would be higher, if they are
purchased at a lower market price (below par). Thus rate of interest and bond market
price has inverse relationship to each other.
If the bond prices are expected to fall, it would mean that the interest rates are expected to
go up. People would tend to sell their holdings with a hope to earn higher interest in
future. They will first convert their holdings into cash and keep that cash till the prices of
bonds actually fall. In that case, they are able to purchase more bonds with the same
amount of cash due to fall in prices and thus, in future, they will earn more interest and
vice versa
This is the most important canon of taxation. In the words of Adam Smith, Every
subject of a state ought to contribute with their respective abilities in proportion to the
revenue that they respectively enjoy under the protection of the state. It means that every
citizen of a country should pay taxes according to their ability but not necessarily in the
same amount. The rich person should pay more than the person with lower income. This
canon also implies equality of sacrifice i.e. the higher the income the greater the sacrifice
22
one shall be called upon to make. This canon was put in the forefront of all other canons
with the view that all others have been derived from this one
2.2.6 Supply of Money
There are two views of supply of money narrow view and broader view. In the narrow
view of money supply or the volume of money in circulation, the money supply is
measured by the volume of money held by the public in a country in the form of currency
(notes and coins) and demand deposits (bank deposits transferable by cheques).
It
includes only volume of money held by the public. Public here means individuals and
business firms operating in the economy but it does not include the Central Government,
the central bank and the commercial banks. Thus the money supply means the money
held by individuals and business firms. Money held by the Central Government in its
treasury, and lying with the central bank and commercial banks is not included in the
total supply. This is because of the two reasons:
(i)
It is not in circulation, and
(ii)
It might result in double counting because demand deposits form part of money
supply.
Thus, at a given point of time, total money in circulation is the total amount of money
supply that includes:
(i)
Currency (notes and coins) and
(ii)
Demand deposits of the public with the commercial banks.
This may be referred to as M1. It is the most widely accepted measure of money supply
for it includes only those assets which are generally acceptable as a means of payment.
Currency means legal tender money issued by the Government or the central bank. Its
general acceptability as a means of payment has made it an important constituent of
money supply. Likewise demands deposits held by commercial banks on behalf of the
public and can be withdrawn by cheques are also considered money as they are also
accepted as a means of payment. According to this view, time deposits and savings are
not money.
Broader View: A majority of economists prefer the narrow definition of money supply
that includes currency and demand deposits in money. But a group of economists
23
strongly supports the store of value function of money. They point out that savings and
time deposits are close substitutes for currency and demand deposits and as such these
should also be included in the measure of money supply. They are of the view that time
deposits and savings frequently and easily changeable from time deposits to currency and
demand deposits and therefore they consider all bank deposits (time deposits and demand
deposits) in money supply, even though time-deposits cannot be used for making
payments. This measure of money supply is referred to as M2. Thus
Or
M2 = M1 + Savings and time deposits.

M2 = Currency + Savings + Time deposits + demand deposits
Milton Friedman, the worlds foremost monetarist, believes that M2 is the correct and
best measure of money supply.
2.2.7 Items excluded from money supply
The following items are not included in the concept of money supply of a country:
(a)
The stock of monetary gold kept in reserve by the central bank as a cover for
issuing paper currency is not included in money supply. It is so because, it is not
permitted to circulate within the country.
(b)
The cash held by the commercial banks is also excluded from money supply as
they form the basis of deposit money of the public.
(c)
The cash held by the Government in treasury and by the central bank of the
country is also not included in money supply as it constitutes the reserve on which
the demand deposits of the public are supported.
2.2.8 Components of Money Supply

The main components of money supply are:
1.
Coins
2.
Paper currency and
3.
Demand deposits
1.
Coins
Coins mean metallic coin issued by the monetary authority of the country, the
central bank. There are two systems of coinage:
(a)
24
Free coinage, and
(b)
i.
Limited coinage.
Free coinage is a system under which everybody is free to get the coins
minted at the mint against the metal. Free mintage or coinage may be
gratuitous or non-gratuitous. Gratuitous coinage is that where government
does not charge anything for coinage whereas non-gratuitous mintage
means where the government charges for mintages.
ii.
Limited coinage means where public is not authorized to get the coins
minted. The government mints on its own account. In other words, the
government enjoys monopoly over the minting of coins. Today, almost in
every country, the system of limited coinage is in vogue.
Coins were once the principal type of money in circulation, but now subsidiary
coins are in currency to facilitate transactions of smaller denominations. Now
metal used in coins is not important.
2.
Paper Currency
Paper currency is the most important part of the monetary system today. The
government or/and the Central Bank of the country issue notes. Almost in every
country, the central bank enjoys the monopoly over note issue.
The paper
currency in a country is regulated by the monetary system/policy laid down by the

monetary authority.
Broadly speaking, three main systems of note-issue are
current:
(a)
The fixed fiduciary system;
(b)
The proportional reserve system; and
(c)
The minimum reserve system.
(a)
Under the fixed fiduciary system, the monetary authority is authorized to

issue notes up to a certain limit without having any metallic reserves.
Above that limit, 100 per cent metallic reserve is required to be
maintained.
25
(b)
Under the proportional reserve system, a fixed percentage of total note

issue is required to be kept in gold reserves and the remainder remains
uncovered. This system was adopted in India upto 1956.
(c)
Under the minimum reserve system, a minimum amount is to be kept in

gold or silver reserves and then the monetary authority is permitted to
issue notes to any extent.
This currency is an important component of the money supply. The currency

component coins and notes is determined by the monetary authority according
to the monetary policy adopted by the central bank in consultation with the
Central Government.
In deciding the total volume of currency, the monetary authority is generally
guided by the economic requirements of the country.
Some economic
considerations are volume of trade, nature of trade, price level in the country,
method of payment i.e., cash or credit instruments, amount of demand deposits,
bank habits of the public, distribution of national income, etc.
3.
Demand Deposits
Now a deep, demand deposits have also occupied an important place in the total
money supply. Demand deposits are deposits of the public in commercial banks
where the bank is under an obligation to pay the amount to the extent of deposit
on demand to the depositor or to anybody else as directed by the depositor. Thus,
the people increasingly accept cheques for discharging their financial obligations.
This is the reason why demand deposits are treated as a part of money supply.
2.2.9 Determinants of Money Supply

Having discussed the components of money supply, we shall now turn to the
determinants of money supply. There are basically two determinants of money supply i.e
the monetary base (high powered money) and the money multiplier.
As we have already defined that M (money) is equal to the currency (C) including both
notes and coins, demand deposits of banks (DD) and other deposits in the nature of time
deposits (OD), all held by the public i.e.
26
M = C + DD + OD
One of the determinants of money supply is High Powered Money (H). High Powered
Money is money by the central bank and the government and held by the public and the
commercial banks. It constitutes currency held by the public (C), cash reserves of banks
(R) and other deposits (OD), thus:
H = C + R + OD
The difference between M and H is that whereas the former includes demand deposits,
the latter includes reserves held by banks in place of demand deposits. We now present
very briefly a widely held theory of money supply known as high-powered money theory
or money multiplier theory.
The second important determinant of money supply is that money multiplier that
influences the quantum of money supply. The theory says that the supply of money (MS)
is a highly stable increasing fraction of high powered money (H). in other words, it
implies that:
(i)
As H changes, M changes, in the same direction, and
(ii)
That most of the change in M is due to the change in H.
Symbolically, the theory can be presented as such:

MS = mH
Here, Ms = Money Supply, m = money and multiplier and H = high powered money.
The equation deals with the determination of the total money supply, not just change in
the money supply. Now, we shall see how these two factors m and H are determined.
Money Multiplier Process. The money multiplier m is determined when the reserve
requirements on demand deposits (RD), reserve requirement of time deposit (RT),
currency ration (C/D) and the time deposit ratio (T/D) is determined. With the variations
in these ratios, the money supply will also change. From the above equation, it follows
that m varies with these ratios and supply of money is positively related to the money
multiplier (m) or money supply varies in the direction of change in m.
We have observed earlier that:
27
M = C + DD + OD, and
H = C + R + OD
Thus currency (C) and other deposits (OD) are directly a part of M and also of H. the
ratio between C and OD is decided by the public. The rest of H i.e. R stays with banks,
through their interaction with the public and the government it serves as the base for the
secondary creation of deposits.
This results in multiply expansion of money, bank
deposits, and bank credits and constitutes the heart of the money multiplier process. The
process has been explained as follows:
Suppose, one rupee is injected in new H in the form of new demand deposits with banks.
This increases their reserves with full one rupee. The bank will keep a part of this rupee
in the form of reserves as per the requirement of the law and lends the rest. The recipient
will spend it in the market. Those who receive payments will retain a part of it and
deposit the balance with the banks, partly in the form of demand deposits and partly in
the form of time deposits. This causes a further increase in the time and demand
deposits. The return flow of a part of bank credit again induces the bank to lend the
balance keeping a part of fresh deposit as reserves in the second round. Their actual
reserves thus will be higher than the derived reserves. The process continues till banks
have retained their desired ratio and public its desired currency and time deposit ratios.
The process leads to multiple creations of bank credit, bank deposits and money. Hence
it is called the money multiplier process and also the credit multiplier process. The
process thus, can be summarised as follows:
(a)
The supply of money (MS) is positively related to m.
(b)
The money multiplier (m) is inversely related to

(i)
reserve requirement on demand-deposits (RD);
(ii)
reserve requirement on time deposits (RT)
(iii)
currency-deposit ratio (C/D)
(iv)
time deposit ratio (T/D)
Thus, the quantum of money is determined by high powered money (H) and money
multiplier (m).
28
2.2.10 others determinants of money supply

The sources of changes in money supply are as follows:
i.
Open market operations: Open market operations refer to the selling and buying
of the government securities on the open market by the central bank. A reduction
in money supply will occur if the government sell its securities through its brokers
since buyers will pay for these securities with cheques draw on their accounts
with the commercial banks. Conversely there is an expansion of money supply if
securities are bought on the open market by central bank and paid for by cheques
drawn upon the central bank. In this case, money supply will further be increased
if commercial banks undertake a multiple expansion of bank deposit.
ii.
Interest rate policy: since liberalisation of interest rate in 1991, the central bank
influences the general level of interest rate by means other than the direct
prescription of the deposits and the 90-day. Treasury interest rate. Which
significantly affect the other rate of interest in the economy since commercial
banks constitute important buyer of this financial asset? An increase in this rate of
interest tends to reduce money supply and credit creations.
iii.
Changing the cash reserve ratio: an increase in the cash reserve ratio reduces
the credit multiplier and hence reduces the money supply. A reduction in cash
reserve ratio is likely to increase the credit multiplier and hence increase money
supply.
iv.
Special deposit: the central bank of Kenya has the power to require commercial
banks to lodge special deposit with it. Which compulsory they ensure a reduction
in commercial banks liquid asset and reduce the banks ability to increase credit
and hence the money supply.
v.
Government expenditure financed by borrowing the central bank: if currency

issued by the government to finance its expenditure money supply will increase
and conversely a reduction in government borrowing from central bank will
reduce the rate of growth of money supply.
vi.
Government borrowing from the banking system: if the public sector is

running a deficit it may want to borrow some funds from the banking system
which may lead to further expansion of money supply.
29
vii.
A change in the publics desired cash holding: a decision by the public to hold
more cash and small bank deposits will reduce money supply through its effect on
credit creation. If the public decides to hold less cash and bigger bank deposit,
money supply would be increase through a higher degree of credit creation.
viii.
A change in banks demand for excess reserves: most models in the

determination of money supply assumes that banks will adhere to a constant ratio
of cash reserve to deposit on the assumption that banks will wish to expand
deposit to the maximum. In practice, however, banks could decide or be forced to
hold cash reserve in excess for legal requirements as happens in many developing
countries. This could happen if there are an insufficient number of credits worthy
borrowers. In this case, the bank cannot be sure of success if it uses open market
operation to increase money supply.
ix.
Balance of payment disequilibrium: a balance of payments involves a net

outflow of foreign currency and the central bank has to finance the deficit by
providing foreign currency in exchange for domestic currency. Unless offset by
an expansionary open market operation, this will result in a reduction in the
money supply. Conversely, a balance of payment surplus involves net inflow of
currency and unless offset by a contractionary open market operation will result in
an expansion of the money supply.
30
Discuss the Keynesian approach to the asset demand for money
Explain the determinants of Transactional demand for money
Define high powered money
2.2.12 Self Test Questions

Give reasons why demand deposits forms part of money supply
The demand for money is unique and insatiable discuss this statement fully
Highlight reasons why some items are excluded from the money supply
Explain the relationship between high-powered money and ordinary money
Write a note on the money multiplier
2.2.13 Summary
In summary, in this lecture we have learnt that;
Demand for money is made for two reasons; i) it serves as a medium of exchange, ii) it
works as a store of value Money
The stock of monetary gold, cash held by Commercial banks and Central bank are
excluded from the money supply
2.2.14 Suggestion for further reading

Related to this lecture, you can read further on;
Credit multiplier
Money supply in the Kenya
31
3.0 LECTURE THREE: THEORY OF MONEY AND PRICE

3.1 Introduction
Money is the life blood of the modern economies. We cannot think of an economy
without money. Money is used as a medium of exchange and it is its most important
function. .What a unit of money buys, in terms of commodities and services
represents its true value. But it is very difficult to measure the value of money, in
terms of each and every commodity. It is for this reason that the value of money is
expressed-in terms of general price level' which may also be called as the
purchasing power of money.
Just as the price of a commodity. May increase or decrease, the general price, level
may also move upward or downward. The fluctuations in the general price level
have a great impact on the, value of money. General Price level and the value of
money are inversely related. 'If the price level goes up, it means the one unit. of
currency can now purchase less commodities and services i.e. the value of 'money
Or the exchange value- of money has decreased. On the contrary the fall in general
price level may increase the value of money. Thus, value of money means its
purchasing power in terms of commodities and services.'
'
Economists' have formulated a number of theories to explain the relationship

between the- supply of' money and the general price level.
3.2 Specific Objectives

By the end of this lecture the student should be able to;
32
Explain the Fishers quantity theory of money
Identify the equation of exchange
Highlight the assumptions of the theory
Criticize the theory
3.3 Lecture Outline

3.3.1 Quantity theory of money - Fishers approach
3.3.2 The Transaction Approach
3.3.3 Equation of Exchange
3.3.4 Assumptions of Fishers Equation
3.3.5 Criticism of the Fishers equation
Fishers Quantity theory of money
3.3.1 Quantity Theory of money (FISHER'S APPROACH)
The Quantity Theory of money was first expounded by an-Italian economist Mr.
Davanzatti but the theory was popularized by the American economist, Irving Fisher who
gave it a quantitative form and explained by an equation known as Equation of Exchange.
At present, there are two versionsi) The transaction approach, (transaction approach is associated with Irving Fisher)
(ii) The cash balance approach.
3.3.2 The Quantity Theory of Money The Transaction Approach
The value of money implies what a unit of money can buy in terms of' commodities
and services. The price of commodities or the general price level does not remain
constant hence the value of money 'also fluctuates. The two have inverse relationship. If
general price level increases, the value of money decreases or the value of money
'increases with the decrease in general price level.
The quantity theory of money indicates that the value of money in a given period
depends upon the quantity of money in circulation in the economy. The quantity' of
money supply determines the general price level and the value of money. Any change in
the money supply will change the general price level directly and the value of money
inversely in the same proportion. e.g. if the quantity of money in circulation is doubled
other things being equal, the general price level will be doubled and the' value. Of
money is halved. Similarly, if the quantity of money is halved, the price level will be
halved and the value of money will be doubled. Prof. FW. Taussig has stated the
33
tendency of this theory thus"Double the quantity of money, and other things being equal; prices will be twice as high
as before; and the value of money as, one-half. Halve the quantity of money, and other
things being equal; prices will be one half of what they were before and the value of
money double."
According to J.S. Mill,' "the value of money, other things being the same, varies
inversely as its quantity ; increase of quantity lowers the value and every diminution
raising it in a ratio, exactly equivalent
3.3.3 Equation of Exchange

The transaction version of the quantity theory of money was presented by Irving. Fisher
in the form of an equation known as equation of exchange as given belowMV=PT
Where
M = Quantity of money in circulation
V = Velocity of circulation of money. It denotes average number of times a unit of
money changes hands.
P = Price level
T"= Total volume of transactions of goods and services during a' given period of time.
The above equation has two sides i e. MV and PT.
MV represents total supply of money in the economy
M represents the total money supply in circulation but a unit of money does not
purchase goods and services. in ' a given period of time, only once. It changes hands by a
number of times. Hence total money supply is represented by the 'quantity of money
multiplied by its velocity which is represented by MV in the equation:
PT, on the other side of the equation represents total demand for money or the money
value of all the goods and services brought during a given period of time. Hence total
volume of transactions (T) multiplied by the price level (P) denotes the total demand of
money.
Thus MV=PT. or total supply of money (MV) is equal to total demand of money to
34
purchase the total' transactions at a given price (PT). The equation is referred to as the
cash transaction equation. It could also be .expressed as follows- . '
P=
MV
T
Thus, price level is determined by the total quantity of" money divided by the total
transactions. Thus the total quantity of money determines the price level provided P and,
T are constant.
The above equation was criticized by some of the monetary. experts on the ground that
the theory ignores completely the credit money and .its velocity both of which are.
important in the modern day economy. Irving Fisher, later, extended his original
equation, considering the credit money and its velocity represented by M' and" V'
respectively and put the extended equation as follows:MV+M'V'=PT
Or
P = MV + MV
T
The equation broadly indicates that the price level (P) is directly related to total quantity,
of money (original money and bank money) multiplied by its velocity. It, is, however,
inversely related to T. He has established in his equation the basic proposition that the
price level and the value of money is a function of money supply "provided other things.
remain constant. These other things are M'V. V and T and if they remain constant, price
level will change directly. And: proportionately with the change in money supply. Price
level affects the value of money inversely and thus changes in money supply influences
the value of money inversely.
Example 1;
(i)
The following data relates to economy ABC:

M = 50
V = 10
M1 = 20
V1 = 2
35
T = 450
Compute the countries:

(a)
Price level
(b)
Value of money
Solution
(a)
(b)
50 x10 20 x 20 900
2
450
450
1 1
P
2
P=
Example 2;
If money supply in a given economy equals 1000 while the velocity and price equals 16
and 4 respectively. Determine the level of nominal and real output.
Solution
MV
T
1000 x16
4=
T
P=
1000x16
4
T = 4,000
Nominal output = 4,000
T=
Monetary value of real output

P * Q = 4 * 4,000
=16,000
3.3.4 Assumptions of Fishers Equation
(i) Price level (or P) is a passive' factor. P in the equation (Price level) is inactive' or
passive in the equation. P is affected by other factors in the equation i.e T, M, M' V or V'
but it does not influence-other factors in any way. p. is . Thus a resultant and not a cause.
(ii) T and V are constant. The theory assumes that T in the short period. Remains
constant because T depends upon the volume of production and the production
techniques do not change in the short period. Similarly, V depends upon the size of
population, state of economic development, money habits of the people, which remain
36
unaffected during the short period." Hence T and V have been assumed constant in the
theory.
(iii) T and V are Independent Factors. Fisher assumes that total volume of trade (T)
and velocity of money (V) are independent variables in the equation and are not affected
by the change in any other factor. The volume of trade however, is determined by certain
outside factors. V (velocity of circulation at money) is also independent and was not
affected by change in M or P.
(iv) The Ratio of Credit Money to Legal Tender 'Money Remains Constant. The
theory assumes that the ratio of credit money to legal tender money also remains constant.
If it is not constant the quantitative relation between' money and prices as visualized in
the theory does not hold good.
Thus, four variables in the equation of exchange i.e., M' V, V and T are assumed to be
constant during the short period. P is a passive factor, therefore, the change in the
quantity of money (M) directly affects-the price level (P)
3.3.5 Criticism of the Quantity Theory of money (Fishers equation of exchange)
.
(I) the theory is based upon; unreal assumptions. .According to Fisher P is a passive
factor, T is independent,' MV and V' are constant in the short period. Constant in the
short period. He covered 'up all these assumption under 'other things remaining the
.same'. But according to critics these other things do not remain '. Constant in "the actual
working of the economy hence they are-unrealistic and misleading. For examplei.
The velocity of circulation of money automatically changes with the change in

the quantity of legal tender money.
ii.
there is no well-defined relationship between legal tender money (M) and

bank money (M/),
iii.
Any change in legal tender. Money will ~lso influence the velocity of credit
money (V').
iv.
The assumption that T is an, independent factor and does not change, with the change in 'M. Which is not correct because T cannot remain constant
37
consequent upon the change if} M. lf M increases. P will also, increase,

resulting in higher, profits which naturally' affect the production.
Impliedly, P cannot be assumed as a passive factor. It certainly influence T.
v.
(v) Price level is not an outcome of changes in money supply. P alsoeffectively influences the money supply. Thus, P also determines -M and M
determines P. Both are inter-'
'
Thus, according to critics, the assumptions are not real because other things do not
remain constant.
'
(2) A Long-Term Analysis of Money. The theory offers a long term analysis of value
of money and therefore, ignores the changes in short. Period. 'However, there are certain
violent- and far-reaching changes in the short run in the value of money which the
theory ignores.
(3) How Money-supply influences the price level is not Explained. The theory simply
presents: that the quantity of money affects the price level but it does not explain the
process how it is possible. MV=PT is simply a mathematical equation and 'explains only
that total supply of money is equal to total transaction-value. It throws: no' light on Cause
and effect relationship of money and price. '
(4) No, Direct and Proportional Relationship between' Quantity of Money and the
Price Level. The theory states that every Change in the money supply brings
proportional and direct change in the price level. But in actual life, no such relationship
exists because there are other external factors which disturb this relationship.
(5) Assumption of Full Employment is wrong. Keynes has raised an objection against the theory that the assumption of full employment is a rare phenomenon in a
economy and the theory IS not real. The relationship between M and P does not bold
'good if we assume unemployment in the economy. '
(6) The Theory is not comprehensive. According to Keynes, total legal tender money
arid credit, money does not constitute .the total sup-ply of money, because whole of it is
not used for the purchase of commodities and services. A part of the total legal tender
money is hoarded by the people which is not used for the' exchange of goods and
services. So, the hoarded money should not be considered,
38
(7) Money Supply is not the only factor influencing price level.
The change in price 'level is, not influenced merely by the change in money supply. There
are other factors such as change in national income, national expenditure, savings and
investments. According to, Prof. Crowther the value of money, in fact, is a consequence
of the total of incomes rather than of 'the quantity of money. It is the causes' of
fluctuations in the total of incomes of which we must go in search."
(8) The Theory Neglects Velocity of Commodities. The theory considers velocity of
money but ignores velocity, of circulation of commodities which is a serious drawback of
the theory.
3.3.6 Other Criticism includes;
a) Demand aspect of money is not considered.
b) The expression MV in the equation is not technically a consistent expression. M
refers to the quantity of money at a particular moment of time whereas V refers to the
velocity of circulation over a period of time. This is inconsistent.
c) It is not possible, according to critics, to measure the velocity of circulation of money.
d) According to critics, there, is time lag between the change in, money supply and its
effect on price level. It is not instantaneous' and immediate. It is slow and gradual. It
is possible that other things may not remain constant by that time.
(e) The theory also does, not consider the changes in the price ,level of other countries
which also affect the domestic price level without any change in money supply.' ,
The; above' criticism of the quantity theory of money assert that the theory is imaginary,
defective and' misleading. Keynes called it incomplete. The theory also lacks
mathematical exactness. But, it explains the tendency which. is Correct: hence the theory
occupies an important place in economics.
39

1. If money supply in a given economy equals 4000 while the velocity and price equals 20
and 4 respectively. Determine the level of nominal and real output.
2. Comment on the following statements:
a) The quantity theory of money is a theory of demand for money
b) The quantity theory of money is a theory of Money-Income determination
3.3.7 Self-Test Questions
Supposing the politicians in country XYZ decide to increase money supply to

finance their campaigns by printing more coins and paper money, such that the new
M = 100 and M1 = 40. Other factors remaining constant, compute the new:
(a)
Price level
(b)
Value of money
(c)
Interpret your findings
Critically assess Fishers quantity theory of money
3.3.8 Summary
In summary, we have learnt the following;
The equation of exchange represents the two sides i.e the demand and the supply side
of money( MV-Supply, PT- Demand respectively)
Price is passive and do not affect other factors but a resultant of the factors,
Keynes equation represents the real cash balance equation,
3.3.9 Suggestion for further reading.
Related to this lecture, you can read further on;
40
Monetarist view on the Quantity theory of money,
4.0 LECTURE FOUR: THEORY OF MONEY AND PRICES

CASH BALANCE APPROACH TO THE QUANTITY THEORY
4.1 Introduction
Fisher's approach' was "based on the medium of exchange function of money. It
emphasized the demand side of money. But ' a different approach to the quantity theory
of money has been attempted by' the Cambridge economists,' like Marshall, Pigou,
Cannan, Robertson .and Keynes. This approach is known as Cash- Balance approach or the Cambridge Version of the quantify theory of money. This approach is based on
the 'store of value', function of money. The approach emphasizes the demand side of
money.
According to this approach, the value of money is determined on the basis of its demand
and supply. When the demand for money is equal to its supply, the value of money, like
other things is settled. The changes in the value of money are thus caused by changes
either in its demand or in its supply or in both. In this way the approach is based on the
general theory of value and is applicable to the problem of money. The approach
considers the demand for and supply of money at a particular point of time, rather than
over a period of time enunciated by the transaction approach.
According to cash balance approach, the supply of money is its stock at a particular
.time not its flow over a period of time and comprises all the cash and bank deposits
subject to withdrawals by cheque. Demand for money, according to this approach, has
been interpreted in a different manner.
According to Fisher the demand for money is not for its own sake. 'It is made only to
purchase the commodities and services i.e. money is demanded because; it serves as a
medium of exchange.
But this theory emphasizes that the demand for money is made for meeting their day to
day requirements by individuals, firms and governments, thus, the demand for. Money
refers to that quantity of money which the individuals, commercial firms and the
government hold to meet its day to day requirements. Thus the supply of money set
against the community's aggregate demand (or cash balances) determines the level
41
of prices or the value "of money in the economy. If demand is constant, only change
in the supply 'of money will directly affect, the price level and inversely the money
value.
On the other hand, if supply is constant, the price level will change inversely and money
value directly with any change in the demand for money. An increase in the demand for
money (for store purposes) will lower down the demand for goods and services because
people can now have a larger cash balance only by cutting their expenditure on goods
and services consequently the price level will fall and the money value will go up.
Converse will be the case with the fall in demand for money.

Differentiate between cash balance approach and Fishers approach to the quantity
theory of money,
Understand the Cambridge/ Cash balance equations
Highlight the criticism of the theory
4.3 Lecture outline

4.4.1 Introduction
4.4.2 Equations of cash balance approach
4.4.3 Similarities of Fishers Approach with the Cambridge Approach
4.4.4 Differences between Fishers and the Cambridge approach
4.4.5 Criticism of the Cash Balance Approach
4.4.2 Equations of cash balance approach.
(1)/ Marshall's EquationMarshall's cash balance equation is
M=KY
Where,
M represents total supply of money
K is that portion of income which they want to hold in the form of money.
42
1<; is that
Y is the aggregate real national income
K, in other words, is the reciprocal of velocity.
Since the total money income Y equals the total real output
(0) times the price level (P), the above equation can be presented as;
or
M
K PO
M__
KO
This approach emphasizes that a shift in the magnitude of K significantly influence the
price level even though the supply of money (M) remains constant. Thus, it is K and
not M that influences the money value.
(2) Pigou's Equation
Prof. Pigou bas de
Prof. Pigou developed the equation as-
P = KR
M
where, P represents the value of money, K stand for the-proportion of total real income
to be held, in cash, R represents total real income and M is total quantity of money. The
equation later enlarged considering the fact that all people do not hold cash strictly in
the form of legal tender money. Some of them have cash in the form of bank deposits
also.
The enlarged equation isP
KR [c + h(1 c)]
M
KR [c + h(1 c)]
P
43
Where c represents cash in legal tender money, h represents the proportion of cash
reserves to deposits held by the bank.
(I-c) stands for the proportion of legal tender money which is kept in, the form of bank
deposits,
For explaining the changes in the value of money, Pigou emphasized on K rather than
on M.
(3) Robertsons Equation
Prof. D.H. Robertson equation is somewhat different from that of Prof. Pigou. The
equation isM
PKT
M
KT
Or
Where,
P = Price level
T=total amount, of goods arid. services to be bought during a year,

K= that proportion of T which the people desire to hold in the form of cash.
(4) Keynes Equation
J.M Keynes, a noted Cambridge economist has presented his own equation known as
'The Real Balance Quantity equation:
or
PK
n
K
Where, n = total supply of money in circulation

P = Price of consumption goods
K = Total quantity of consumption units which the people went to held in cash.
Keynes refers to K as the real balance
In the above equation, so long as K remains unaltered, the price level will change
directly in proportion to change in n. .
Keynes further enlarged his equation taking bank deposits into account. The enlarged
equation is44
n=P (K+rK)
Or
n
K rK '
Where,
r = proportion of bank reserves to their deposits
K' = number of consumption units which the public keeps in' the form of bank
deposits. Other symbols carry them. Same meaning as given above.
Assuming K, K' and r constant n and P have direct and proportional relations. The
proportion between K and K' is determined by the banking arrangements of the public
and their absolute value is determined by the habits of the people. The value of r is
determined by the practice of hanks to hold cash reserves. So long as these values remain
constant n and P have direct relation.
4.4.4 Criticism of the Cash Balance Approach
The Cambridge version of the quantity theory of money or the cash-balance approach has
the following short comings .
i.
The theory assumes that the elasticity demand for money is unity which is
not possible in the dynamic society of today.
ii.
The cash - balance approach does not consider all the determinants of the
demand for money .e.g. it ignores the speculative motive of holding
money which causes a violent change in the demand for money.
iii.
The serious defect in the Cambridge equations is that they seek to explain
the value of money in terms of consumption goods only. It is wrong and
illogical. The equations completely ignore the reference of capital goods;
iv.
According to theory, the real income only determines the value of k (i.e.
cash to be held by. people). Whereas there are other determinants of k in the
real life than real income, such as, the price level, monetary and business
habits and political conditions of the country etc.
v.
According to the Approach, cash holdings by the people (K) determine the.'
purchasing power of money or the price level. It is also not correct. Critics
pointed out that K not only influences P but is also influenced by it. At a
45
time of rising' prices, K falls because the people want to buy today rather
than wait for tomorrow. The K (cash holding) would rise in case of a fall
in prices. Thus, K is also influence-by the change in the price level (P).
vi.
It is difficult .to visualize in terms of cash balance approach the extent to

which prices and output will change; consequent upon a given change in the
supply of money. The theory thus lacks quantitative exactness.
vii.
The Cambridge equations also assume K and T as constant. It thus, open, to

the same criticism as the Fisher's equation,
viii.
The cash-balance approach ignores those bank deposits which come into
existence consequent upon the lending operations of the banks. Thus, the
approach considers only primary and not 'the derivative bank deposits
Derivative bank deposits 'are not the less important than the primary
deposits
ix.
The cash balance approach, while explaining the changes in the price level;
completely ignores certain important factors as income, saving and
investment which have an important bearing on the price level. Moreover,
the approach attributes all changes in the price level to changes in the
demand for money which is not correct. What is worse, the theory does not
bring out all factors; which cause changes in the demand for money.
Despite, the above shortcomings Criticism, the approach is not entirely useless. The
great merit of the theory is that it considers. Demand for money also, as the main
determinants. of the value of money'.
4.4.5COMPARISON OF FISHER'S APPROACH'WITH CAMBRIDGE'

APPROACH
Similarities between the two Approaches
Following are the similarities between the two approaches,
(1) Both the theories lead to the same conclusion that it is the quality of the money
that determines the value of money and the price level.
(2) MV+M`V` in fishers equation, M in Robertsons as well as Pigous equations
and n in Keynes equation refer to the same things i.e. the total quantity of
46
money.
Note
In Fishers equation credit money has been represented separately by M` but
i.
in Cambridge equations, credit money has not been separately shown

because the total quantity of money implies credit money also in this
dynamic world of today.
In Fishers Equation velocity of legal tender money and credit money have
ii.
been represented separately by V and V` where as in Cambridge equations,

there is no mention velocity of circulation of money.
(3) The cash balance equation of Robertson, namely, P
equation namely P
M
KT
and Fishers
MV
resembles with one another. The symbols used in the
T
two equations are almost the same. The only difference relates to V and K. But
even V and K are reciprocal to each other. In Fishers equation V
in Robertsons equation K
K
PT
which
M
M
Thus, K is reciprocal of V. In other words
PT
I
I
or V
.There is no fundamental difference in the two equations.
V
K
Rather they represent different aspects of the same phenomenon.

(4) Fishers equation and Cambridge equations, according to Robertson, are not
basically different from each other. Rather they explain the same thing with two
different angles. Fishers equation stresses money as a flow while Cambridge
version emphasizes money as stock.
4.4.6 Dissimilarities between the approaches

(1)
The
two
version
make
use
of
different
concepts
of
demand
(or money in transactional approach, the demand for money is to exchange goods and
services and thus it stresses medium of exchange function of money. Whereas, in cash.
47
Balance approach, the. demand for money is to store and thus it emphasizes the 'store
'of value function of money.
(2) The two approaches have different notions of money: In Fisher's approach, the
emphasis is laid on velocity of circulation of money. (V) While the cash balance
approach, 'the stress is on the idle. Cash balance that is a fractional part of the national
income (K). It should be noted that V is exactly opposite of K,
(3) Fisher's equation explains the value of money over a period of time while the
Cambridge equations explain the value of money at a point of time. When we
consider a period of time, velocity becomes important because money during that period
is expected to perform a variety of functions. At a given point of point money simply
represents some goods and services. Here K plays an important role: It is for this reason
that V is emphasized in Fisher's equation and K in Cambridge equation.
(4) Symbol P in two types of equations is not identical in meaning. P in Fisher's
equation represents general price level whereas P in the Cambridge equations refers to
only the prices of consumption goods.
Which version of the Theory is Superior and why?

The study of the two versions of the Quantity Theory of money (cash transaction) and
cash balance their similarities and dissimilarities, establishes the superiority of the
Cambridge version i.e. cash balance approach. the points in this support. Are(1) Fisher's version is mechanical whereas Cambridge version is realistic. Fisher's
version is-mechanical in the sense that it treats price level as the exclusive function of
the quantity of money in circulation. It accords no place to human motives. The
Cambridge version on the other hand, .make consideration of human motives by
emphasizing
in
determining
the
price
level.
The
size
of
is
more or less determined by human motives i.e., store of money .

(2) Fisher's version considers only the quantity of money (i.e., supply of money) as
the sole determinant of the value of money, Whereas the Cambridge version considers,
on the other hand, both the demand and supply aspects of money in determining the value
of money. . The Cambridge version is. Thus more comprehensive than Fisher's- version.
48
Fisher's . Version, thus, may be considered as incomplete.

(3) The Cambridge version is wider and more comprehensive from another point of
view also. Fisher's version does not consider the income level as a determinant of price
level. The price level, _ according to this version, is determined by the quantity of supply
(supply of money) and the total number of transactions whereas in Cambridge version,
price level is influenced by the income level and. the changes in it.
(4) Fisher's equation explains that price level changes only when there .is a change in
the supply (total quantity) of money in circulation. But the Cambridge version explains
that price level may change even without any change in the quantity of money, if K
undergoes a change. If people prefer "holding more-cash balances (if K changes), the
price level will also undergo a change without any change in the quantity of money; Thus
K is more important determinant than M.
(5) The Cambridge version stresses subjective factors as the main determinants of
the demand or money. Fisher's approach. Takes into account only objective factors
while,
discussing
the
demand
for money. On the' above ground, the Cambridge version enjoys a superiority over
Fisher's approach to, the Quantity Theory of Money.
49

Explain why the Cambridge approach is also referred to as the Cash balance
approach,
Discuss why elasticity of money is not unitary in a modern economy today?
Examine similarities between the two approaches,
4.4.8 Self Test questions

Compare and contrast Fishers quantity theory of money and the Cash Balance
approach to the quantity theory of money,
Discuss the Cambridge Cash balance approach to the quantity theory of money. How
far is it superior to the fishers transaction approach,
Describe why Keynesian equation is referred to as the Real Cash Balance equation,
4.4.9 Summary of the lesson

Cache Balance approach is superior to the Fishers quantity theory of money
Keynes equation is considered as the real cash balance equation

The students can further read on Bloomers quantity theory of money
50
LECTURE FIVE: KEYNESIAN VIEWPOINT ON THE QUANTITY THEORY

OF MONEY
5.0 INTRODUCTION;
Liquidity refers to the degree to which assets can be quickly and cheaply turned into
money which, by definition is completely liquid.e.g, a current account bank deposit is a
liquid assets since it can be withdrawn immediately at little cost. An office building,
however, will take substantial time to dispose of and some costs, such as estate agents
fees will be incurred.
An organization or individual is said to be liquid if a high
proportion of its or his assets are held in the form of cash or readily marketable securities.

By the end of this lecture, the students should be able to;
Define liquidity,
Understand the motives why people hold wealth as money rather than as interest
bearing securities,
Explain why demand for money is interest elastic,
Describe the limitations of the monetarists theories
5.2
5.3 Lecture outline;
5.5.1 Introduction
5.5.2 Motives why people hold wealth as money rather than as interest
bearing securities
5.5.3 Total demand for money
5.5.4 Keynesian view on interest rates and money supply and demand
5.5.5
Effects of an increase in the supply in the Keynesian view
5.5.6 The Monetarist view point

5.5.7
Limitations of the monetarist theories
5.5.8 Implications of the Keynesian and Monetarist theories for economic policy
51
5.5.2 Liquidity preference refers to the desire to hold money rather than other form
of wealth.
Keynes used the concept of liquidity preference, which refers to the demand for money,
to explain:
i. How savings and investment might temporarily be different.
ii. How interest rates in the economy are arrived at.
Keynes identified three reasons or motives why people hold wealth as money rather than
as interest-bearing securities.
These are as follows:
a)
The transaction motive. In this case household need money to pay for their day
to day purchases. The level of transactions demand for money depends fundamentally
on the individuals incomes and on institutional arrangements such as how often the
individual is paid and how often he or she engages in monetary transactions.
b)
The precautionary motive. In this case money is held in order to finance
unplanned rather than planned transactions, resulting for example from unexpected illhealth or a car breaking down. Precautionary demand for money is also likely to
depend on the level of income. The higher the total value of the transaction, the more
money will be needed to guard against unexpected transactions. Interest rates may also
influence precautionary demand. The interest rate is the opportunity cost of holding
money and so if interest rates rise, consumers and firms may be forced to reduce their
precautionary holdings and instead hold interest bearing assets. However, for purposes
of simplicity we assume that the precautionary demand does not respond to changes in
interest rates. In this way we can combine precautionary demand with the transactions
demand and suppose that the total of both depends on money national income.
c)
The speculative motive. In this respect people may choose to keep ready money
to take advantage of profitable opportunities that may arise in financial markets such as
to invest in bonds which may arise (or they may sell bonds for money when they fear a
fall in bonds market prices). When analysing the speculative demand for money. It is
52
important to understand the relationship between the price of a bond and the rate of
interest.
A bond is an asset that earns a fixed sum of money for its owner each year. There is an
inverse relationship between the price of a bond and the rate of interest which implies
that if interest rates go up bond prices will fall and vice versa.
Individuals would hold money instead of investing in bond if they expect interest rates to
rise. For example, if the current market prices of bonds which pay 5% interest is Kshs10,
000 and the interest rates doubled to 15% the market value of the bonds would fall,
perhaps to Kshs. 5000. This is because Kshs. 10,000 invested in another income-earning
asset would earn a return of Kshs. 500. If the market rate of interest now rises to 10%,
the price of the bond would fall to Kshs 5000 because Kshs 5000 invested in any incomeearning assets will now yield Kshs.500. Similarly, if the rate if interest should fall to say,
4%, the price of the bond would rise to Kshs.12500. An increase in the rate of interest
therefore reduces the saleable value of a bond and signifies a potential capital loss for an
investor who bought it at a high price. A fall in the rate of interest, on the other hand
signifies a potential capital gain for investors.
Keynes argued that each individual has some expectation of a normal rate of interest,
although these conceptions differ from one individual to another. This notion of normal
interest rate reflects previous level and movements of interest rates and expectations of
the future level derived from the available market
information. If the current interest
rate were greater than the individuals conception relating to the normal rate, the
individual would expect the interest rate to decline in the near future. This implies that
the higher the prevailing rates of interest, the greater the number of people who would
anticipate that the rate will fall in future.
Given that a fall in the interest rate implies capital gains for holders of bonds, the theory
predicts that if interest rates are high there will be a large demand for bonus and,
therefore, a small demand for speculative money balances. On the other hand, if the
interest rates are low, people will expect them to rise in the future. Individuals will,
therefore, hold more money in order to satisfy the speculative motive and, consequently,
the demand for bonds will be lower. Keynes, therefore, derived an inverse relationship
between the interest rate and the speculative demand for money which is shown below;
53
Interest
rate
I1
I2
Speculative Demand
I3
0
Q1
Q2
Quantity of money
5.5.3 The speculative demand for money

As the interest rate falls from i1, to i2 the speculative demand for money increases from
Q1 to Q2. However, at the low interest rate i3, bonds become so unattractive because
their prices are high and are expected to fall that the speculative demand for money
becomes perfectly elastic.
The total demand for money or the liquidity preference is found by adding together the
transactions, precautionary and speculative demands.
There is a minimum fixed demand for money (made up of the transactions and
precautionary motives) and some demand for money which varies with interest rates
(speculative demand). This can be shown as a liquidity preference curve.
In the figure below, the total demand for money is plotted against the interest rate. T is
the minimum quantity of money needed, regardless of the interest rate, to satisfy the
minimum demand, arising transactions and precautionary motives for holding money.
When liquidity preference curve is elastic as demonstrated by a shallow slope, the
government will find it difficult to alter the interest. If the interest is lowered from i1 to
i2 an increase in money supply (Q2 to Q1 ) is required. An equal fall in the interest rate
54
Interest
rate
i1
i2
i3
Q1
Q2
Q3
Quantity of money
5.5.4 Total demand for money

From i2 to i3 requires much large increase of (Q3-Q2) in money supply. Liquidity
preference becomes increasingly elastic at lower rates of interest as households are
willing to give up large quantities of bonds for cash in response to very small changes in
interest rates. Liquidity preference could even become infinitely elastic at a very low
interest rate.
The horizontal part of the liquidity preference cure is known as the
liquidity trap. In this situation of abnormally low interest rates, virtually everyone could
expect the interest rate to rise towards its normal level in the near future. This implies
that there would be a widespread expectation of a fall in the price of bonds and
corresponding capital losses for holders of bonds. In such a situation an increase in
money supply would be entirely added to speculative balances and would have no impact
on the interest rate.
5.5.5 Keynesian view on interest rates and money supply and demand
If the money supply is assumed to be fixed by the government, the size of the money
supply is perfectly inelastic with respect to changes in the rate of interest. Keynes argued
that the level of interest rates in the economy would then be reached by then be reached
55
by the interaction of money supply(fixed) and money demand (liquidity preference) as

shown below;
Q Money Supplied (fixed)
Interest
rate
Minimum
demand for
money
Determination of interest rates through interaction of money demand and money

supply
0
Quantity of money
In the above figure, the level of interest rates in the economy (i) is determined by the
interaction of money supply which is fixed by the central bank and money demand
represented by the curve LL.
An increase in the money supply from MS1 to MS2 leads to a fall in the interest rates
from i1 to i2 as shown in the figure below;
MS1
MS2
Interest
rate
I1
I3
0
56
Quantity of money
5.5.6 Effect of an increase in the money supply in the Keynesian view

According to the Keynesians, therefore, an increase (or decrease) in the money supply
only indirectly affects the demand for goods and services, and hence the level of income,
via a change in the rate of interest. Thus, for example, an increase in money supply leads
to a fall in the rate of interest which in turn causes private investment to fall and
ultimately results in a decline in the level of national income. The impact in the economy
of an increase in the money supply depends on the effect that the fall in interest rates
produces. According to the Keynesian view, both investment demand and consumer
demand are relatively insensitive to interest rate changes that are they are relatively
interest-inelastic. Keynes argued that the volume of investment depends heavily on
technological changes and business confidence, and also expectations. This implies than
an increase in the money supply will have only a limited effect on aggregate demand and
consequently, relatively little effect on output and employment.
Keynesians argue that monetary policy will have a limited effect on the economy and
national income, because increases in the money supply would be neutralized by
reductions in the velocity of circulation. Leaving PT unaffected.
5.5.7 The monetarist viewpoint
The monetarist argue that since money is a direct substitute for all other assets, an
increase in the money supply, given a fairly stable velocity of circulation, will have a
direct effect on the demand for other assets since there will be more money to spend on
those assets. If the total output of the economy is fixed, then an increase in the money
supply will lead directly to higher prices.
Monetarists, therefore, reach the same basic conclusion as the old quantity theory of
money, Arise in the money supply will lead to a rise in prices probably also to a rise in
money incomes.
Monetarists also assume that the velocity of circulation remains fairly constant, thereby
taking a view to the old quantity theory.
In the short run, monetarists argue that an increase in the money supply might cause some
increase in real output and so an increase in employment.
57
In the long run, however, they argue that all increases in the money supply will be
reflected in higher prices unless there is longer-term growth in the economy.
The monetarists argues that the private sector is basically stable and therefore the
fundamental cause of economic fluctuations are the in appropriate government actions.
The monetarist school is therefore opposed to the existence of a large public sector and
contends that the money supply is the key determinant of the production level in the short
run, and a rate of inflation in the long run.
In order to minimize uncertainty, the monetarist advocate the maintenance of a constant
rate of growth of money supply .The monetarists school include; Milton Friedman,Karl
Brunner, David Laidler and Milton Parkin
5.5.8 Limitations of monetarists theories
i)
The theory assumes that the velocity of circulation is relatively stable and on this
basis, they establish a direct connection between money supply and inflation. In
practice, however, the velocity of circulation is known to fluctuate up and down by
small amounts
ii)
Price increases will not affect all goods equally. The prices of some goods will
rise more than others and so the relative prices of goods will change.
iii)
A relatively higher rate of inflation in one country may adversely affect that
countrys balance of payments and exchange
rate thereby introducing
complications for the economy from external factors

iv)
In practice, prices in the economy may take some time to adjust to an increase in
money supply.
Some Keynesians also argue that it is incorrect to assume that the money supply is an
independent variable under the control of the government .They argue that in certain
situations the money supply is completely demand determined which implies that any
increase in PT can cause an increase in the demand for money which may automatically
be matched
by an increase in the money supply. This is especially the case where the
government wishes to hold the level of interest rates stable and so permit the money
58
supply to increase in order to achieve this. The monetary authorities cannot

simultaneously control the money supply and the interest rate
5.5.9 The implications of Keynesian and Monetary theories for economic policy
Keynesians argue that an economy experiencing a depression can be revived through an
appropriate fiscal policy.
Fiscal policy refers to the use of government expenditure and taxation to regulate the
aggregate level of economic activity.
By increasing investment or government expenditure, an initial stimulus to expenditure,
will through the multiplier accelerator interaction result in an even greater increase in
national income.
According to Keynesians, it is unimportant to consider that the increased expenditure
must be financed through borrowing. They argue that the size of the public sector
borrowing requirement (PSBR) has no effect on interest rates. This they contend is
because, although it is possible for PSBR to be responsible for growth of money supply
will lead to higher inflation.
Monetarists, however, disagree with the Keynesian demand management approach to
dealing with a depressed economy. They argue that such an economy cannot be
successfully revived by an increase in public expenditure given that any increase in
expenditure will normally have to be financed by increased borrowing.
The effect will be to further depress the economy through higher interest rates, through
the crowding out of the private sector investment (the crowding out effect). Increased
borrowing will also increase the money supply thereby causing more inflation.
Monetarists argue that the focus should be on creating the conditions for confidence in
the economy and incentives for enterprise. Inflation ifs seen as a key obstacle to
confidence and according to monetarists, it can be reduced by controlling the growth in
money supply and reducing inflationary expectation
59
5.5.10.
Learning activity
Explain any three reasons why people want to remain liquid,
Highlight the limitations of the monetarist theories,
Use a suitable illustration to explain the total demand for money,
5.5.11.
Self-test
Outline the major difference between quantity and Keynesian liquidity preference
theories of money demand,
With the help of a diagram, explain why demand for money is interest
elastic,
rate
Explain the implication of Keynesian and Monetarist theories to the Kenyan

economy,
5.5.12 Summary of the lesson;
Arise in the money supply will lead to a rise in prices and probably a rise in the
money income,
Monetarist argue that an economy cannot be successfully be revived by increase

in public expenditure given that any increase in public expenditure will have to be
financed by increased borrowing,

The students can further read on the Kenyan interest rate and the money supply
60
LECTURE SIX: INCOME THEORY OR SAVING-INVESTMENT

6.0 INTRODUCTION
The two versions of the Quantity Theory of money - Fisherian and Cambridge-have lost
its: importance in this dynamic world as they fail to explain the value of money and
other factors relationship. The two approaches conclude that. it is the change in the
quantity of money that results' in the change in price level or the value of money. They
ignore other determinants of price level such as savings, investment, expenditure etc.
completely. The two approaches also fail to explain the processes why the changes in
price level take place in the economy.
.
There is another theory explaining the process how the price level changes take place,
known as income theory of money' as developed by: J.M. Keynes. He developed a
systematic and complete analysis of the income theory in his famous book 'General
Theory of Employment, Interest and Money'. Contrary to Quantity theory, the income
theory seeks to relate price fluctuations with several other elements such. As income,
expenditure, saving investment etc. The theory is also known as 'saving-investment
theory of money' because these two factors simultaneously influence the. Price level.
The theory considers the economy as a whole.
The income theory explains that changes in income results in the changes in aggregate
demand of goods and services. It is .not the volume of money that changes the price
level. The theory asserts that the aggregate money income of the society determines the
aggregate demand of goods and services. An increase or decrease in the aggregate money
income implies a similar change in the purchasing power of the community which affects
the price level in the same direction provided there is no change in the volume of
production. Thus, changes in money income and not money supply bring about changes
in price level due to changes in aggregate demand. In fact, money supply itself, may
change due to the changes in the level of aggregate income, savings, investment, prices,
and other economic activities. The theory may be .summed up in the following words.
"The value of money or the price level, in fact, is the consequence of the aggregate
income rather than the supply of money".
61

Define real money and money income,
List and explain the importance of the Saving-Investment ,
Utilize the knowledge in the modern economy,
Income can be saved or consume, saved or invested,
6.2 Lecture Outline;

6.6.1
Introduction
6.6.2
Explanation of the theory
6.6. 3 Importance of the theory

6.6.2 Explanation of the theory
The theory can be explained as followsThe term 'income' has been interpreted in two senses
(i)
money income, and
(ii)
(ii) Real income,
Money income of the community may be .referred to as the sum total of the
monetary reward received by the various factors of production during a given period
of time the monetary reward of the different factors of production is equal. to the
value of goods and services. Produced during the period. Hence money income
represents the value of goods and services produced during a particular period of
time.
The real income, is the aggregate output of goods and services in a

community during a given period' of time. It is determined by two elements.
Namely;
(a) Factors 'of production' available to the community for productive purposes, and
62
(b). the effective demand in the community for the goods and services without which
no entrepreneur would like to engage various factors of production.
The income of the community will be used in the satisfaction of aggregate effective
demand that will result in expenditure. The expenditure may be either on consumption
goods or on capital or investment goods. thus expenditure may be consumption
expenditure or investment expenditure. The aggregate expenditure of the community
(consumption as well as investment expenditure) will be equal to the aggregate value of
the output The aggregate expenditure of the community will again be equal to aggregate
income of the community a one man's expenditure will be other man's income. , Hence
aggregate expenditure is always equal to aggregate income or in other words aggregate
income arises from the sale of consumption and investment goods. Thus every
expenditure; creates an income which, after being spent, creates another income. Thus
aggregate expenditure and aggregate income of the community must be equal. It infers
that level of income of the community depends upon the level of expenditure. Larger the
expenditure, larger is the money income and again larger the aggregate income, larger is
the aggregate expenditure.
The, aggregate expenditure defines the effective demand and determines the real income
or the level of output and employment in the community. Thus, aggregate expenditure is
the real determinant of output, employment and prices. Aggregate expenditure, thus, has
direct relation with output, employment and prices and the economic activity as a whole
is governed by the aggregate expenditure. Thus the income theory explains how
aggregate demand aggregate expenditure and aggregate income determines the value of
money or price level. The price is determined by the money income and real income (or
output of goods and services). Thus, the income theory of prices can be expressed in
algebraically form as followsP
Y
0
Where,
P represents the general. Price level,
63
Y stands for money income and

O for total output of goods and services or real income. Thus, the general price level (P)
can be found out by dividing the total money income by the total output of goods and
services. If money income rises faster than the output of goods and services, the prices
will show an upward tendency. If money income does ,increase with slow speed but it
does not change at all, as compared to the increase in output, the prices will fall or in
other words if output increases more rapidly than the money income, the result will be a
fall in the price level. . Thus, will compare Money income and the real income (output of
goods and services) to arrive at the general price-level or the value of money.
J.M. Keynes has presented the above ideas in his theory named as the SavingInvestment Theory. According' to this theory, there is an disequilibrium in the
savings and investment which causes-price fluctuations through changes in the
income level. If the saving and the investment are in equilibrium there will be no change
in the price level or value of money. The equation as given by Keynes explaining
The theory is
Y=C+S (i)
(Y=Income, C=Consumption, S=Savings)
According to him, the total. Income is not totally consumed. A part of it is saved. The
saving is then invested, thus the equation may be put as;
Y=C+I(ii)
(Here I =Investment)
By combining the two equations, we find
Y=C+S
or
Y=C+I
or
C+S = C+I
or
S=I
From the above equation of Keynes, it can be concluded that- .
i.
At the point of equilibrium, saving and investment are equal. Hence S=I.
ii.
Money income is always equal to the amount spent for consumption purposes and
money saved during a period of time
64
iii.
Total supply of money in the market is the amount spent on consumption +

amount spent for investment by the entrepreneurs.
Thus, any increase in saving will be available for investment. If saving exceeds
investment, the price level will fall or money value. Will increase. Contrarily, if
investment exceeds saving, the price level will go up and money value will fall. Any
disequilibrium thus is harmful to economy. So, efforts should be made to strike a
balance between the two.
6.6.3 Importance of the Saving- Investment Theory
OR
Superiority of the theory over Quantity Theory of money
The saving-investment theory or income theory is superior to the traditional theory of
the value of' money.
i.
The Saving-Investment theory has a good combination of the two theories i.e., the
general theory of value (the theory of individual prices) and the theory of money (the
theory of general prices). It therefore; presents a more comprehensive view of th
price fluctuation's than the classical theory of the value of money (i.e: the quantity
theory of money)
ii.
The older quantity theory of money established that any change in the quantity (or
supply) of money will affect the price level, directly and proportionately, if other
things remaining constant. Thus, it presents a very simple explanation to money-price
relationship.
The savings-investment. Theory is rather complicated as it describes a series of events
that lead to the changes in price level; Changes in the supply of money lead to changes
in the rates of interest bringing about a change in the relationship between saving and
investment. This change in relationship, in their turn influence the level of income,
employment and output which ultimately brings about a change in price level. If
investment exceeds saving, prices will rise or if saving exceeds investment, the price
will fall; this establishes a better relationship between money and prices.
iii.
The Saving-Investment theory provides a tool for analyzing the cyclical fluctuation in
65
prices, employment and output. According to this, theory, business' cycle is nothing
but an altering expansion and contraction of national income: It .is, "therefore, a
distinct improvement over the quantity, theory of money.
iv.
The quantity theory of money' has assumed the situation of full employment which is
not a realistic assumption because the situation of full employment does not exist in
any economy. The Saving-Investment theory, on the other hand, does not assume full
employment as the basis of theory.
v.
The quantity theory of money does not explain why the velocity of money changes or
the factors that change the velocity of money. The Saving-Investment theory, on the
other hand, throws light on changes in the velocity of circulation of money from time
to time. Thus, the theory is better than the quantity theory of money.
Despite its proven merit, the theory suffers from one serious limitation. That it answers only of
the short-term fluctuations in prices and employment.. It does not provide answer for the long
term fluctuations in prices and employment. Whereas, the quantity theory explains the long term
fluctuations in prices at full employment stage. Thus, the quantity theory of money also cannot be
scrapped out rightly
66
6.6.4.
Learning activity
Bring out the difference between money income and real money,
Explain the importance of the theory,
Describe why economy is said to be in equilibrium when S=I, according to the

theory,
6.6.5 Self Test questions

Discuss how the income of the community is used to satify their aggregate demand
Explain the application of the Income-Saving investment theory to the modern
economy
Is this theory more superior to Fishers and Cambridge approaches? Give reasons to
support your answer,
6.6.6 Summary of the lesson;

The theory assume the economy is in equilibrium when Savings equal Investment, i.e
(S =I)
Income of the community is used to satisfy their aggregate demand

The students can further read on superiority of Saving-Investment Theory to the Cambridge
and the Fishers Quantity theory of money
67
7.0 LECTURE SEVEN: MILTON FREDMAN VERSION TO THE QUANTITY

THEORY OF MONEY
7.1. Introduction
After Marshall and Pigou, the developments in the theory of demand for money have
taken two different paths. One path of development is represented by the Keynesian
theory of money demand and its modifications and extension made by Baumol, Tobin
and others. The second line of development is represented by Friedmans quantity theory
of money. The difference between the two lines of development is the different in how
money treated in the formulation of the theory of demand for money. In the first line of
development, pre and post-Keynesian economists treated money as a sterile form of
wealth and demand for money is prompted by different kind of motives like transaction,
precaution, speculation and the store of wealth.Frieman, whose quantity of theory
represent the second line development, treat money as any other durable good and he
treat the demand for money in exactly the same way as an economist would treat any
other durable good where he ask to construct a model for the demand for it. Therefore he
applies the standard theory of demand for durable goods to explain the demand for
money as an asset. In this section we describe Friedmans quantity theory of money in its
simplest form.

Define the demand for money according Freidmans view
Formulate the demand for money ,
Compare Freidmans view with those of Marshall, Pigou and John Keynes,
Understand the demand for money according to business firms,
7.3 Lesson outline;
7.7.1 Introduction
68
7.7.2 Determinants of demand for money

7.7.3 Wealth holder demand function for money
7.7.4 Demand for money by business forms
7.7.5 The aggregate demand for money
7.7.6 The conclusion
7.7.2 Determinants of Demand for Money
Friedman has formulated his theory of demand for money in terms of real money defined
M/P where M is income in nominal terms and P is price index. For specifying the
determinants of demand for real money, Friedman makes a distinction between the two
kinds of ultimate wealth-holders viz., the individual households and business firms. The
demand for money by the ultimate wealth-holders, in general and that by individual
households and firms are discussed below in turn.
7.7.3 Demand for money by Ultimate wealth-holders
For ultimate wealth-holders, money is one form in which they choose to hold their
wealth. According to Friedman, the demand for money, in real terms, by the ultimate
wealth-holders may expect to be the function of the following variables.
1. Total wealth
Total wealth include both non-human (physical) and human wealth. In practice, estimates
of wealth are seldom available. Therefore, he considers permanent income as more useful
index of total wealth. It is important to note that income is surrogate for wealth, rather
than a measure of the work done by money or a purchasing power.
2. Proportion of human wealth in total wealth
The major asset of most wealth-holders is their personal earning capacity, i.e their human
wealth. Due to institutional constraints, the conversion of human to non-human wealth or
reverse is possible within narrow limits. That is, one can buy physical assets by using
ones current income or can finance education and acquire skills by selling ones nonhuman assets, but within narrow limits. Therefore the fraction of total wealth that is in the
form of non-human wealth [is] an additional important variable.
69
3. The expected rates of return on money and other assets

Analogue of the prices if a commodity and its substitutes and complements in the usual
theory of consumer demand. The rate of return f money is zero, sometimes even negative
as in case of demand deposits ( i.e. deposits in current account). But the rate of return on
the other forms of assets, like bonds, equities, securities, is greater than zero. There is
therefore a relative cost of holding money. This relative cost fluctuates with the
fluctuation in prices. During the period of hyperinflation, for example, the real rate of rate
of return may not be significant different form zero. Therefore, the relative rates of real
returns also work as a determinant of demand for money.
4. Other variables
Other variables includes: (a) the service rendered by money as an asset compared to other
forms of wealth, that is, in fact, the advantage of liquidity and transaction convenience,
(b) the degree of economic stability expected to prevail in the future. As regards (b)
wealth holders are likely to attach considerably more value to liquidity when they expect
economic conditions to be unstable.
7.7.4 Wealth-holders Demand Function for money
Friedman has symbolized these determinants into to a demand function S for money by
an individual wealth-holder as follows.
M/p=f(y; w; rm; rb; re; p/p; u)
(15.11)
Where M=demand for nominal money; P=price index; M/P=demand for real money; Y=
real income; W= fraction of wealth in non-human form, that is, the ratio of income
derived from property; rm = expected rate of return on money; rb = expected rate of return
on fixed valued securities, including expected change in their prices; re = expected return
on equities, including expected change in prices; p/p = expected rate of change of prices
of goods and hence expected rate of return on real assets; u = any variable other than
income which may affect the utility attached to the services of money.
Friedman has pointed out the problem in applying this demand function for economy as a
whole. The problem arises due to the problem of aggregation that may arise due to:
i) Change in distribution of real income (y) and the fraction of non-human wealth
(w).
70
ii) Problem in defining y and w in estimating expected rate of return as contrasted

with actual rates of return, and in quantifying the variables classified under u.
However, if the problem of distribution of y and w are ignored, Eq. (15.11)
may be applied to the economy as a whole, but the problem of quantifying
variables under u will remain.
7.7.5 Demands for Money buy Business Firms.
To business firm or enterprises, money is a producers good like machinery or
inventories. However, Friedman suggests that the demand function for money specified
for the ultimate wealth-holders can be used for business enterprises also with the
following modifications.
One, the demand for money by business enterprise is not subject to the total wealth
constrains applicable to the ultimate bond holders. The business enterprise can acquire
additional capital through the capital market in order to maximize their returns. Hence,
there is no reason on this ground to include total wealth, or y as surrogate for total wealth,
as variable in their enterprise as a substitute variable for total wealth. However, as he
points out there are several measures of scale total transaction, net value added, net
income, net value added, net income, total non-money capital and net worth. But none of
this is measurable satisfactorily and usable.
Two, the division of wealth between human and non-human form has no special
relevance to business enterprises.
Three, the rates of returns on money and alternative assets are as much important for
business enterprises as for the ultimate wealth-holders, as these rates determine the net
cost of holding the money balances. However, different kinds of rates of return on the
alternative assets are relevant and important for the two kinds of wealth-holders. For
example, rates charge by the banks on loans and advances may be of minor importance
for the business enterprises.
Four, the variable classified under u may be equally important for both kinds of wealthholders, accept, of course, scale related productivity in case of ultimate bond-holders.
71
7.7.6 The Aggregate Demand for Money.

According to Friedman, with these interpretation of the variables, the money demand
function is given in Eq. (15.11) with w excluded, can be regarded as symbolizing the
business demand for money and, as it stands, symbolizing aggregate demand for
money too.
7.7.7 Concluding remarks.
Friedmans theory is a theory that specifies certain variables being potentially important
determinates of the demand for money might be expected to bear toward them. It does
not however say anything about how large or important any of these relationships might
be, leaving these matters to empirical investigation, one cannot say more than this about
[Friedmans] approach to the problem of demand for money without reference to
empirical evidence, and this limitation is hardly surprising. Friedman theory of demand
for money does not tell more about the relative importance of its determinants than the
standard theory of demand tells about the relative importance of the determinants of
demand for other consumer durables.
Furthermore, Friedman himself holds that his theory has closest link to Cambridge
version of the monetary theory, it is rather a restatement of the old quantity theory of
money. Many economists, however, find Friedmans theory closer to the Keynesian
theory. For example, Don, Patinkin remarked,
Milton Friedman provided us in 1956 with a most elegant and sophisticated statement of
modern Keynesian theory misleadingly entitled The Quantity Theory of Money-a
Restatement.
72
7.7.8 Lecture activity

Explain the variables that determine the demand for money
Describe the demand for money according to wealth holders
7.7.8 Self test questions

Explain Friedmans reformulation of the quantity theory of money,
Critically examine the statement that the revised version of the quantity theory of
money is that there exists a stable demand function for real money holdings
7.7.9 Summary
In summary, we have learnt the following;
Friedman believe that wealth can be held in five different forms namely; money,
Bonds, Equities, Physical non-human goods and Human Capital.
7.7.9 Suggestions for further reading

The students can further read on the Fishers and the Cash balance approach and
compare with the Milton Friedmans approach
73
8.0 LECTURE EIGHT: MONETARY POLICY
8.1 Introduction
Monetary policy can be defined as one of the public interventionist measures aimed at
influencing the level and pattern of economic activity so as to achieve certain desired
goals. It is said to cover all actions by the central bank and the government which
influence the quantity, cost and availability of money and credit in the economy.
Specifically, monetary policy works on two principal economic variables:
Aggregate supply of money in circulation and
Level of interest rates.
Many developing countries place a lot of emphasis on monetary policy to accelerate an
orderly process of economic development. Monetarism as a doctrine holds that monetary
policy is determinant of aggregate demand. J.M. Keynes holds that in the short run fiscal
policy is important and that monetary policy matters only in as far as it affects fiscal
variables.
In Kenya, the Central Bank carries out the technical work of formulating and executing
the monetary policy. A principle objective of the Central Bank of Kenya as laid out in
the Central Bank of Kenya (Amendment) Act 1996 is to formulate and implement
monetary policy directed to achieving and maintaining stability in the general level
of prices.
The Central Bank therefore tries to impose excessive level of credit obtaining in the
economy does not impose excessive strains on the available resources while at the same
time, it ensures that monetary policy provides a general environment in which savings
can be accumulated to the maximum possible and utilized to support productive
investment.
In conducting its monetary policy, any monetary authority must make
decisions as to whether to target any monetary variable or not and also to make a
corresponding decision of which variable to target. It is not, however, possible to set up
targets individually for the money supply, the exchange rate and interest rates since the
three are simultaneously determined.
74
The central bank is to set targets for the increase in domestic credit of the banking system
and to contain growth in money supply to levels consistent with the attainment of credit
targets.
The central bank uses a number of monetary instruments to achieve its goals in monetary
policy. Moreover, it should be noted that apart from certain inherent problems associated
with the operation of monetary policy, Kenya as a developing country, experiences
certain special problems with respect to its monetary policy.

Explain the objectives of monetary policy
List various instruments of monetary policy
Describe the limitations of monetary policy in developing country
8.3 Lecture Outline

8.8.1 Objectives of monetary policy
8.8.2 Instruments of Monetary policy
8.8.3 Limitations of Monetary policy
8.8.1 The objectives of the monetary policy
(i)
The attainment of full employment. It would be idealist to argue that the only
acceptable level of employment is zero employment. Full employment can thus
at least be said to be consistent with some functional unemployment as potential
workers search for employment. Moreover, it is argued by some economists that
a certain amount of structural employment is acceptable since individuals without
jobs may not have the skills needed by employers, at least in the short run.
Monetary policy can raise the level of employment by discouraging credit to
capital-intensive sectors, while at the same time, directing investment to labourintensive sectors like rural agriculture and light industries like those dealing with
75
textiles through selective lending. In addition, a policy that lowers the rate of
interest constitutes expansionary monetary policy and is likely to lead to increased
investment and hence more job opportunities.
(ii)
The achievement of price stability. This has been, by and large, the problem of
avoiding inflation.
Unanticipated inflation reduces the ability of money to
effectively perform its functions, especially as a store of value and as a standard

of deferred payments. Moreover, price stability can be maintained by regulating
money supply through the tools of the central bank such as discount rate,
minimum reserve requirements and open market operations.
(iii)
To attain economic growth which can be defined as a process whereby the

real GNP per capital increases over a period of time. Monetary policy can
contribute to this end by providing investment funds through cheaper credit and
by mobilizing savings which can then be used for investment. The flow of funds
can be institutionalized so that investment funds are allocated to those sectors
with the highest rates of return. This better allocation of resources brings about
increased output.
(iv)
To maintain an equilibrium in the balance of payments. Here monetary policy

can be used in such a way that credit is selectively directed to the export sector
and away from the import sector.
At the same time capital inflow can be
encourage and outflow discouraged through say exchange controls.
Another
related goal is that of exchange rate stability which often requires the intervention
of policy makers in the foreign exchange market.
(v)
The creation of sound banking and financial institutions to mobilize savings

for capital formation. Thus, branch banking should be encouraged in rural and
urban areas. While this objective could be regarded as a means to achieving the
previous goals, it is also a consideration that appears to be an independent goal.
76
The most important conflict of goals concerns reconciling price stability and full
employment.
Thus an increase of aggregate demand tends to promote output and
employment, but at the same time creates inflationary pressure. On the other hand, lower
rates of increase of aggregate demand tend to promote price stability but have their cost
in terms of lower rates of increase in employment and real output. This problem can be
resolved by assigning weights to the various objectives, although there has been much
criticism of policy makers in regard to their perceived choices of relative priorities.
8.8.2 Instruments of monetary policy
The Central Bank has several instruments of monetary control, which it has employed on
various occasions.
(i)
The minimum liquidity assets ratio. The liquidity assets ratio can be defined as
the proportion of the total assets of a bank, which are held in form of cash, and
liquid assets. This instrument affects banks lending and has the advantage that it
affects all banks equally and has the advantage that it affects all banks equally and
has a powerful effect in controlling credit creation since it is a direct method and
its effects are immediate. A related instrument has been the cash ratio whereby
the central bank may instruct commercial banks to keep a higher or lower
percentage of deposits received by them in cash form. The Central Bank may
also require commercial banks to maintain minimum cash balances with it against
their total deposit liabilities although the maximum prescribed balances may not
exceed 20% of total deposit liabilities. The main purpose of this instrument is to
reduce the banks free cash base and hence their capacity to give loans and
advances.
(ii)
Open market operations as an instrument of monetary policy has also received

increasing emphasis on recent times.
It refers to the sales or purchases of
marketable securities conducted in the open market by the central bank as an

instrument of control over the monetary system. Open market operations target
the cash balances of commercial banks and non-bank financial institutions. In
their tills and also in relation to their excess reserves at the Central Bank. The
nature and extent of the operations depend on the extent of the excess or
77
deficiency in the liquidity level relative to the target. The Central Bank sells its
holdings of government securities to commercial banks in order to mop up excess
reserves with commercial banks.
On the other hand, whether it anticipates
liquidity deficiency it injects additional liquidity by purchasing from the existing

stock of government securities.
(iii)
Selective credit control. This is a qualitative measure of credit control used to

encourage those sectors of economy activity considered essential and to
discourage those, which are of lower priority. This policy has been effected by
the Central Bank through issuing special directives regarding loans, advances or
investments made by commercial banks. The Central Bank is also authorized
under its statute to impose limits on any category of loans, advances or
investments made by commercial banks.
Thus, for example, it may advice
commercial banks and other financial institutions to approve loans for industrial
development and limit lending for speculative purposes.
(iv)
Interest rate policy is yet another instrument of monetary policy used

extensively. It has been official policy in Kenya to follow a low interest rate
policy for the purpose of encouraging investment and protecting the small
borrower. Moreover, stability of interest rates has also been emphasized since it
is regarded as an important factor in promoting development. The interest rate
regime was liberalized in 1991. This policy left the market forces of demand and
supply to determine the appropriate interest rate levels.
(v)
The exchange rate can also be used as an instrument of monetary policy,

although it has been controversial since the inception of the Central Bank. An
exchange rate refers to the price of one currency in terms of another. It has been
argued that frequent changes in the shillings exchange rate would adversely affect
investment because of the associated uncertainty. Exchange rate policy seeks to
ensure balance of payments equilibrium and persistent differences between
foreign receipts and payments over a long period indicate that the exchange rate
and domestic policies are not compatible with developments in the external
sector. Such a situation calls for change in either or both types of policies.
78
8.8.3 Limitations of monetary policies in developing countries

(i)
Markets and financial institutions in many developing countries are highly

disorganized with many developing countries operating under a dual monetary
policy system with a small organized money market catering for the financial
requirements of middle and upper class individuals, and a large disorganized and
uncontrolled money market to which most low-income individuals are forced to
turn in times of financial need. Due to the lack of developed money and capital
markets and the limited quantity and range of financial assets the use of
instruments like open market operations for economic management is severely
limited.
(ii)
Commercial banks in developing countries are less sensitive to changes in their

cash base partly because many banks find themselves with excess liquidity
because of the scarcity of viable projects and creditworthy borrowers. Thus if
commercial banks have a higher level of liquidity then the legal minimum
liquidity ratio, a reduction in their reserve assets need not bring any response in
terms of reduction in credit.
This limits the effectiveness of open market
operations and the cash ratio as instruments of monetary policy in developing

countries.
(iii)
Many commercial banks in developing countries are merely overseas branches of

major private banking institutions in developed countries.
Thus, foreign
commercial banks can turn to parent organizations for liquid funds in the event of
having their base squeezed by local monetary authorities.
(iv)
In developing countries there is no direct linkage between lower interest rates,

higher investment and expanded output. This is because investment decisions are
rarely sensitive to interest rate movement with business expectations being a
much more important variable determining investment. Additionally, because of
inflation many developing countries experience negative real rates of interest.
Also, severe structural supply constraints such as bureaucratic rigidities and
79
absence of essential intermediate producer may limit the expansion of output even
when demand for it increases leading to increased inflation.
Public sector
investment which is significant in developing countries is not likely to be very

sensitive to change in interest rates.
(v)
The ability of developing country governments to regulate national money supply

is constrained by the openness of their economies and by the fact that the
accumulation of foreign currency earnings is significant but highly variable
source of their domestic financial resources.
(vi)
Many people in developing countries do not deposit their money with commercial
banks.
It is therefore much more difficult for the central bank to use the
traditional instruments of monetary policy to control the money supply.
(vii)
Lack of knowledge about the operation of monetary policy instruments like open
market operations and selective credit controls makes them less effective in
developing countries.
(viii) There is corruption in many developing countries, which make instruments like
selective credit control ineffective.
(ix)
Monetary instruments are sometimes used inappropriately and do not address the
problem that effectively. The policy mix is very important since the problem at
hand may require fiscal rather than monetary policy. In general, monetary policy
is considered more appropriate for external problem like balance of payment
deficits while fiscal policy is more appropriate for internal problem like
unemployment and recession. There is sometimes a conflict between monetary
and fiscal policy objectives.
There is a recognition lag which refers to the elapsed time between the actual need for a
policy action and the realization that such a need has occurred. This lag exists because
80
economic data takes time to collect and also because even with accurate data, reasonable
individuals may take some time to arrive at a common diagnosis. A policy lag may also
exist. This refers to the period of time it takes to pursue a new policy after the need for a
change in policy has been recognized. The final lag, named the outside lag, is the period
of time that elapses between the policy change and its effect on the economy.
Many economists have argued that monetary policy, because it affects the economy less
directly than fiscal policy, will have a longer outside lag.
Moreover, the issue of
uncertainty always arises since policy makers are not always sure of the outcomes of
policy actions.
Thus, raising interest rates may not discourage borrowing since an
entrepreneur may be anticipating sufficiently great returns on investment such that small
changes in interest rates would be unlikely to make a potentially scheme unprofitable.
Conversely, small falls in interest rates are unlikely to turn unprofitable schemes into
worthwhile ones.
81
8.8.4 Lecture Activity

1. What reasons do you have for the inefficiency of monetary policy in Kenya,
2. Discuss the achievements made by the Kenyan government to attain the sound
financial system in the economy,
3. List any four monetary tools and explain how they are used to achieve a desired pattern
of development,
8.8.5 Self-Test Questions

Discuss how the Kenyan government uses the monetary tools to influence the
performance of the economy,
Given the current inflation rate in Kenya, explain how the monetary authority
would utilize price stability as a monetary objective to control the situation,
Describe how corruption in developing countries makes some instruments like
selective credit control ineffective,
8.8.6
Summary
Monetary policy is said to cover all actions by the central bank and the government
which influence the quantity, cost and availability of money and credit in the
economy
A policy that lowers the rate of interest constitutes expansionary monetary policy
and is likely to lead to increased investment and hence more job opportunities
In the short run fiscal policy is important and that monetary policy matters only in as
far as it affects fiscal variables
Outside lag is the period of time that elapses between the policy change and its
8.8.7 effect
Suggestion
Further Reading
on thefor
economy.
The students can further read on fiscal policy
82
9.0 LECTURE NINE: FLUCTUATION IN THE VALUE OF MONEY

(INFLATION AND DEFLATION)
9.1 Introduction.
Inflation has been defined as;
1.
Too much currency in relation to the physical volume of business being done
2.
Issue of too much currency
3.
A state in which the value of money is falling, i.e. prices is rising.
The above definitions seek to establish a relationship between the supply of money and
the general price level. Supply of money is the cause and rise in general price level is the
effect. According to these definitions, every increase in general price level is caused by
the supply of money in excess of what is actually required to transact the business. The
upward trend in general price level may be known as monetary inflation.
Another is Pigous approach that establishes relationship between money income and the
output. It is known as output and income approach. According to Prof. Pigou
inflation is taking place when money income is expanding relatively to the output of
work by productive agents for which it is the payment. Inflation exists when money
income is expanding more than in the properties to income earning activity. The
approach is quite simple when supply of money increases in relation to its demand,
capital accumulation will result in the society. Such accumulated capital shall be utilized
for productive purposes and at lower rates. It will, in turn, increase the production. The
increase in the supply of money, on the other hand, will increase the money income of the
people that may push up the demand for goods and services for consumption.
Production, therefore, will continue to increase to match the demand caused by the
increase in money income of the people. It may bring in a situation where all the
unemployed factors of production would get employment. Pigou has described these
activities as income earning activities. If supply of money increases beyond this point
83
(point of full employment), price rise is imminent because it will not push up the
production. This situation, according to Pigou, is the state of inflation.
J.M. Keynes, linked up the concept of inflation with the phenomenon of full
employment. According to him, an inflationary rise in price level is not possible before
the point of full employment. As soon as, the point of full employment is reached, any
increase in money supply will push up the price level. Thus, according to Keynes, true
inflation is only after the point of full employment is reached.
Thus, approaches of Pigou and Keynes are alike. A common stream of thought running
through most of the definitions is the rising prices. Inflation as a situation in which
general price level in an economy is rising i.e. the value of money is falling. This may be
a monetary inflation or price inflation.

Differentiate between Inflation and Deflation
Explain the various forms of inflation
Highlight measures to wipe out inflationary gap,
Describe economic consequences of inflation and deflation,
9.3 Lecture Outline
9.9.1 Inflation,
9.9.2 Forms or kinds of Inflation
9.9.3 Inflationary Gap
9.9.4 Wiping out of inflationary Gap
9.9.5 Causes and Effects of Inflation
9.9.6 Measures to check on Inflationary Pressure
9.9.7 Deflation
9.9.8 Causes of Deflation
9.9.9 Effects of Deflation
9.9.10 Measures to check deflation
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9.9.11 Inflation Vs. Deflation
Inflation and ITS Different Forms

9.9.2 Forms or kinds of inflation
The inflation may be categorized on the following basis:
(a)
(b)
(c)
(d)
(a)
i.
On the basis of rate of inflation

(i)
Creeping inflation
(ii)
Galloping inflation, and
(iii)
Hyper-inflation.
On the basis of degree of control

(i)
Open inflation, and
(ii)
Suppressed inflation
On the basis of causes

(i)
Credit inflation,
(ii)
Currency inflation
(iii)
Budgetary inflation
(iv)
Demand pull inflation
(v)
Cost-push inflation
On the basis of employment

(i)
Semi-inflation, and
(ii)
Full-inflation
On the basis of rate of inflation

Creeping inflation or mild inflation. Creeping inflation is a situation in which
rise in price level is at a very slow rate over a period of time. Although it is very
difficult to quantify it. Some economists have characterized inflation up to a rate
of 3 percent per annum as creeping inflation. In an economy where national
income is also rising, creeping inflation is not of much consequence. But on the
contrary, there are some other economists who regard a mild increase in price
level a necessary condition for economic growth. A slow pace of rising prices
85
may provide the necessary inducement for investment otherwise, the economy
will stagnate that is not a good phenomenon for the economy.
ii.
Galloping inflation. If mild inflation is allowed to continue for long, it would

result into galloping inflation. Galloping inflation is a situation where prices rise
at a faster rate, say around 8 to 10 percent. Actually, it is a warning signal and the
government should take immediate curbing actions to check inflationary
pressures, otherwise it may uproot the economy. It reduces the saving capacity of
the people and thus may affect the long term projections in the economy.
iii.
Hyperinflation or jumping inflation. It is the last stage of inflation. It is a kind

of inflation in which price line goes up very rapidly within a short period. One
cannot expect a limit of price rise in this type of inflation. It is beyond control
and monetary authorities find it beyond its resources to put any checks on it. In
the words of Keynes, it is full inflation in the sense that it is the final stage of
inflation. This type of inflation was seen after the First World War in Germany
when the price rise was of a galloping speed. This can be said as inflation
without recovery because no efforts of the government may help recover the
economy. It is utterly destructive of all rational society. Every property loses its
value. This type of inflation must be avoided at all costs.
(b)
On the basis of degree of control

On the basis of degree of control over the rising prices, the inflation can be
identified as open inflation and suppressed inflation.
(i)
Open inflation.
Open inflation occurs when prices continue to rise
without any controls and checks. It is referred to, as Milton Friedman put
it inflationary process in which prices are permitted to rise without being
suppressed by government price control or similar techniques.
(ii)
Suppressed inflation. Under this type of inflation price rise is put under
control for a time being by the government through various antiinflationary techniques. Though inflation is not checked forever, but still
it is put under the pressure of some monetary policy which does not allow
the inflationary trend to come up. To quote Paul Einzing, it the inflation
86
is prevented by government measures such as rationing, price control etc.

from producing its effects on prices, it is suppressed inflation. The
balloon gets inflated but it is not allowed to burst. The basic features of
suppressed inflation are:
a)
Building up of inflationary pressures within the economy; and
b)
checks on prices so that:

-
they may help to postpone the price rises;
they may help to divert consumers expenditure on those

commodities which are highly susceptibility to inflation
to those commodities which are not much influenced by
inflationary pressures, and
(c)
they may help to prevent the prices from rising.
Inflation on the basis of causes

(i)
Credit inflation. Banks create credits on the basis of deposits of the

customers. Credit inflation originates due to expansion of credit money
(or near money) which further increases the supply of money without any
corresponding increase in production.
(ii)
Currency inflation.
money in circulation.
When inflation is caused by excessive flow of

It is currency inflation.
It happens when the
government issues more currency without any legitimate demand of

currency to purchase goods and services.
(iii)
Budgetary inflation. In state budget, the government generally shows

more expenditure than revenue.
revenue is left uncovered.
The gap between expenditure and
In this way the government adapts the
technique of deficit financing which increases the money supply and

consequently raises the prices.
(iv)
Demand and pull inflation. Demand pull inflation occurs when demand
of goods and services in the economy is more than their supply. The
effective demand increases due to increased money income of various
factors of production consequent upon the increase in investment in the
87
economy. The pressure of effective demand, thus, increases the prices of

goods and services and of the factor prices in the economy. This type of
inflation generally arises in the post was period when people rush up to
give vent to their pent-up demand for goods and services. The demand
inflation can be checked by the government through monetary and fiscal
measures.
(v)
Cost-push inflation. Cost push inflation is caused by an increase in the

cost of production without any corresponding increase in the productivity.
It is generally caused by two factors:
1.
due to an increase in the wage, and
2.
due to increase in profit margin. The first is know as wage push

inflation and the latter as profit push inflation.
-
Wage-push inflation. It is caused by increase in wages.

Some monopolistic trade unions exercise pressure tactics to
increase the wages of workers which are not invariably be
linked with the increase in productivity.
The pressure
push-up the cost of production and consequently the prices

of commodities and services. This is known as wage push
inflation.
-
Profit-push inflation.
An attempt on the part of
entrepreneurs to increase their profit margins may cause

profit-push inflation. But it is not as much important in
causing inflation as the wage-push inflation.
Because
profit margin does not increase costs but selling price

which may be reduced at any time by the industrialist but
wage inflation cannot be withdrawn.
Thus cost-push inflation is consequent upon the increase in cost of production when costinflation arises in one particular industry, it spreads to other industries and other sectors
of economy because different sectors of economy are knitted with each other. It should
also be noted that demand inflation may soon land the economy into cost inflation. For
88
example, an increase in the prices of consumer goods is invariably accompanied by the

demand of increase in wages for two main reasons:
(i)
to purchase the goods and services available at higher rate, and
(ii)
Increase in demand of consumer goods invariably increases the

price, that way result in higher profit to the manufacturers. Due to
increased demand, prices of raw materials shall also register an
increase, an increase in wages and the prices of raw materials will
naturally lead to the emergence of cost inflation in the economy.
Of the two cost inflation is worse because it is very difficult to
control even through monetary and fiscal measures.
(d)
On the basis of employment

On the basis of employment, inflation is semi-inflation and full inflation.
(i)
Semi-Inflation. According to Keynes, semi-inflation occurs when price

level rises partly due to an increase in the cost of production and partly
due to the increase in the supply of money before the point of full
employment, it is characterized as semi-inflation or bottleneck inflation.
(ii)
Full inflation. This kind of inflation prevails generally in a situation

where the economy has achieved the level of full employment. Any
increase in money supply beyond full employment level, will result in the
rise of prices, since there is no increase in the production as all the factors
are fully employed in the economy.
9.9.3 INFLATIONARY GAP

The inflation comes into being only when money supply continues even beyond the point
of full employment. At this point every increase in money supply shall exert its full
effect on prices, raising them to higher and higher levels. At this point, production will
not increase hence there would be a gap between demand and supply (as demand will be
increasing with the increase in money supply). This gap between the demand and supply
may be named as inflationary gap.
89
The Keynesian concept of inflationary gap represents the technique of statistically

measuring the pressure of inflation in the economy. The inflationary gap for the whole of
economy may be defined as an excess of anticipated expenditure over available
output at base prices.
The anticipated total expenditure in the above definition includes not disposable income
of the community, (consumption expenditure), investment expenditure and government
expenditure. Net disposable income of the community, is arrived at by subtracting
savings and taxation out of the total money income.
Thus
Total anticipated expenditure = consumption expenditure + Investment expenditure and
government outlays or C + I + G (C represents consumption expenditure, I denotes
Investment expenditure and G stands for government outlays). It is the net disposable
income with the people representing the aggregate demand of the community for goods
and services.
The net output available for consumption to the civilians or the public is equal to gross
national product minus the output used by the government for war purposes. It represents
the supply side. These two-the aggregate demand and the available output shall be
priced at pre-inflation prices. The excess of anticipated expenditure (i.e., the demand for
output or C + I + G) over the available output for the community shall represent the
inflationary gap. Or, inflationary gap is a situation where aggregate expenditure or
demand exceeds the available output (or supply) at pre-inflation prices. It can thus
be measured by the difference between the net disposable income (aggregate demand)
and the available output or statistically.
Inflationary gap = Aggregate demand Available output.
The following table illustrates the process of inflationary gap (figures are imaginary).
90
Table: Inflationary Gap

Demand side
Amount
Total money
Supply side
Amount
Gross National Product
Income
800
(at pre-inflation prices)
650
Less Taxes
100
Less War Expenditure
150
Total Disposable Income
700
Available output for Civilian
Less Savings
100
Consumption (at pre-inflation
Net disposable income
600
prices)
500
Hence inflationary Gap = 600 500 = Sh.100

In such an economy where inflationary gap exists, inflation shall continue to develop. If
there is an increase in the private investment or in government expenditure, the money
income of the people will go up to higher level. But the real output of goods and services
will not increase as the economy is already operating at full employment level. The
failure of the economy to raise output in response to the increase in money income results
in the emergence of inflationary gap.
The inflationary gap can also be illustrated by means of the diagram below.
In this figure, the X-axis represents the gross national product or real income of the
society. The Y-axis represents the total anticipated expenditure i.e, C + I + G representing
consumption expenditure, investment expenditure and Government expenditure
respectively.
The 450 line OE is the equilibrium line showing the economy is in
equilibrium when the supply (output) of goods and services equals the demand for them.
The C + I + G curve intersect the line OE at point A that gives the equilibrium income
indicated by OM1. This indicates the full employment income at the pre-inflation prices.
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TOTAL EXPENDITURE
E
C+I+G
NEW AGG.DEM
C+I+G
AGG.DEM
M1
M2
GROSS NATIONAL PRODUCT

(OUTPUT OF GOODS)
At this point, the level of expenditure is equal to the level of money income. The
aggregate monetary demand here is shown by the C + I + G curve which is equal to AM 1.
this AM1 is equal to total output of goods and services amounting to OM1. Since the total
money income is exactly equal to the total available output, hence there is no question of
inflationary gap at this point as there is no excess demand.
Suppose that by any reason, government increases its expenditure by a certain amount,
say, AB as shown in the figure, the economy is assumed to operate at full employment
point, the level of income (or GNP) will not increase with the increased government
expenditure. As such, there exists a gap, AB between the levels of total expenditure (C +
I + G) and the value of national income at current prices. The level of expenditure is
BM1 but national income at current prices OM1 which is equal to AM1. Thus AB
represents the inflationary gap which forces the prices up. It happens when the economy
is at full employment. The flow of money is increased more rapidly than the output of
goods and services. When the expenditure is rising faster than the output of goods and
services, prices will necessary rise to equal expenditure with the money value of output at
a higher price level. The inflationary gap is, therefore, defined as the amount of current
output at current prices, or by which the monetary demand exceeds the value of current
output at existing rates. The price level can remain constant only if the output of
goods and services is increased from OM1 to OM2.
92
9.9.4 Wiping out the inflationary Gap or Measures to bridge the Gap
The inflationary gap can be wiped out in a number of ways. Essentially, it starts with
additional expenditure by the community. It is, therefore, possible to wipe out the
inflationary gap by reducing the government expenditure.
But cutting down the
government expenditure is not always possible in practice during the period of

development or during war time. To remove this inflationary gap, total output should be
increased so as to absorb the additional money supply or aggregate demand.
The
following measures may be adopted to bridge the gap:

(a)
The government may reduce a part of this inflationary gap by cutting down
disposable income through taxes. Taxes may mop up a part of surplus purchasing
power with people.
(b)
The whole of the gap cannot be wiped out through taxes because in that case, taxresistance by the public is bound to be there. So, the government should take
measures to induce the public to save more. It will reduce, again, a part of
inflationary gap.
Both these measures (taxes and induced savings) will reduce the consumption
expenditure (C) and the investment expenditure (I) by the same amount as the
increase in government expenditure.
(c)
Another way to narrow out the inflationary gap may be to increase the output of
consumer goods and services in such a way as to absorb the excess demand. But
as already mentioned that there is no possibility of increasing supply of goods and
services as the economy is already operating at full employment level.
The concept of inflationary gap is very useful concept in economic analysis. On
the one hand, it statistically measures the pressures of inflation and on the other
hand, it highlights the nature and extent of anti-inflationary measures.
93
9.9.5 CAUSES AND EFFECTS OF INFLATION

Inflation is a situation in which the general price level shows an upward trend. In such a
situation prices of commodities and services increase. Generally, it is regarded that every
increase in money supply tends to increase the price level. But it is not so. According to
Pigou and Keynes, the prices of commodities and services do not change, until there is a
state of full employment in the economy, with every increase in the money supply. If
money supply still continues beyond this point, price level is bound to go up. This price
rise is actually inflation.
Causes of inflation
The general price theory states that a price rise may occur due to either of the following
two situations:
(a)
when the aggregate demand increases, and/or
(b)
when the aggregate supply falls
If there is an increase in aggregate demand, without any corresponding increase in supply

or if there is a fall in supply without any fall in aggregate demand, the prices will go up.
Thus, price-rise or inflation is caused by the two sets of causes;
(a)
Causes which induce an increase in demand, and
(b)
Causes which produce a fall in supply due to increase in costs
Inflation caused by the first set of causes is called demand-pull inflation while that
caused by the second set of causes is known as cost-push inflation.
A.
Demand Pull-inflation
Demand pull inflation occurs when the aggregate demand increases without any increase
in output. It means the prices will not go up if output increases along with the demand.
If production is not increasing with the increase in demand, it is a state of full
employment and therefore, demand inflation occurs only when the production reaches at
full employment level. Here, demand is in excess of the available supply at the existing
prices.
Factors responsible for an increase in demand
1.
Money Supply.
Increase in money supply is the major factor that induces
demand for goods and services. Increase in money supply increases, on the one
94
hand, money income of the people that can be spent in purchasing the goods and
on the other hand, it increases bank deposits which are the basis of expansion of
credit. The policies of central and commercial banks are also responsible for the
expansion of credit money. For example, a slash in the bank rates makes the
credit cheaper.
Expansion of actual money and credit money increases the
demand for loans for production purposes. Increased supply of money and bank
credit adds something to the demand of goods and services, on the one hand, and
to the cost due to interest element on the other hand. These factors push up the
prices.
2.
Disposable Income. Disposable income refers to the income payments to various

production factors after personal taxes have been paid.
An increase in the
disposable income results in an increase in the absolute amount of consumption

expenditure in the economy that boosts up prices.
3.
Raising the velocity of money. Velocity of money pertinently goes up during

boom period. It happens when people stop preferring liquid money and their
consumption function dominates the saving attitude. People prefer to spending on
consumption which brings an increase in the velocity of money and thus gives a
spurt to prices.
4.
Deficit Financing.
Deficit financing is a technique through which the
government covers the budgetary gap. When the government spends more than
what it expects to collect as revenue, the deficit is met by issuing more currency
in the market or by borrowing the funds from foreign governments or
international agencies.
It will result in more money in the market and will
increase in price level because the disposable income of countrymen increases.
5.
Increase in Business Outlays. Increase in business outlays, or capital expansion,

takes on a speculative character during an inflationary boom. Most of the new
equipment and plants are financed by speculative borrowing, not to mention an
increase in replacement demand. Most of the expenditure of the business find
their way into income stream via dividend, wages, interest and other income
payments. This income payment also inflationary in character.
95
6.
Increased Foreign Demand. Increased foreign demand will naturally push up

the prices of the domestic goods and services because it increases the overall
demand. This factor is particularly significant if countrys balance of trade is
favourable or exports are higher than imports.
7.
Increase in Population. If the population of a country rises rapidly, it will

pressurize the demand of goods and services. If money supply does not increase,
the velocity of money will increase that will consequently increase the prices
provided the increase in output is less than proportionate to increase in demand
due to increased population. In this regard Prof. Coulborn says, If population
increases rapidly, while the aggregate of money remains stable, the consequent
rise in the velocity of circulation is likely to outweigh the countervailing decrease
in the volume of money per head; further a rapid increase of population may
increase output less than proportionately, another factor tending to raise prices.
The cumulative effect of all these factors is that the aggregate demand functions
in an economy shifts upward, resulting in an inflationary rise in prices.
B.
Cost-Push Inflation
The second major cause of inflation is the increase in the cost of production. When cost
of production increases, the supply curve will go downward, provided there is no increase
in demand at the prevailing prices. Thus increase in cost of production, decreases the
supply resulting in upward trend in price level.
Factors responsible for Cost-Push
The following factors responsible for the increase in cost and consequently resulting in
higher prices are:
1.
Higher Wage Rates. Strong trade unions very often demand for higher wages
for their members and successfully manage to get it because the entrepreneurs
have no other choice. This increase in wages is not linked with the increased
productivity and hence the cost of production goes up. The producers shift this
increased burden on the consumers by charging higher prices for their
96
commodities. This is a never ending wage price spiral. Higher prices of goods
amount to higher cost of living and a fall in real wages. To neutralize the fall in
real wages, again higher wages are demanded and granted which again are passed
on to the consumers and thus inflationary trend continues.
2.
Higher profit margins. Another factor causing cost push inflation is higher
profit margins fixed by the producers. It is especially possible in monopolistic or
near-monopolistic market situations where the producers (or heading producers)
fix up higher profit margins arbitrarily without any increase in other elements of
cost. If some powerful producers succeed in revising their profit margins upward,
the other followers-producers also increase their profit margins and this
phenomenon would push up the prices because profit becomes the part of selling
price. Thus higher profit margins inflate the price level.
3.
Fall in the supply of basic inputs. Whenever basic and strategic raw materials
and other inputs like iron and steel, cement, cotton, etc. go in short supply, their
prices will tend to move upward. The cost of production of finished goods in
which such raw materials are used, increases thereby and consequently their
selling prices also tend to move upward. Higher input prices, thus, would be a
source of cost push inflation.
4.
Higher Taxes. Another source of cost-push inflation is higher tax especially

indirect tax like sales tax, excise duties, etc. imposed by the government. Such
taxes increase the selling prices of the commodities because producers generally
shift the burden of such taxes to consumers. Thus higher indirect taxes push the
commodity prices in the market.
5.
Administered Higher Prices of Inputs. Sometimes, the prices of a number of

important inputs are administered by the government or by supplying agency or
organization.
Such administrators of prices keep on revising the prices of
controlled inputs at regular or irregular intervals. The revised prices are generally
fixed upward. Higher prices of inputs raise not only the prices of outputs in
97
which they are used but they raise the general price level as basic inputs are used
as basic raw materials in a number of industries. For example, prices of crude oil
are administered by the organization of Petroleum Exporting countries (OPEC)
which keeps on revising the prices of crude oil upward from time to time. As oil
is a basic input for a number of industries, it raises the general price level and
therefore establishes a powerful cost push inflationary forces in the economy.
6.
Natural Factors.
Fall in agricultural production owing to insufficient or
excessive rainfall, and other natural calamities like earthquakes, floods, drought
conditions, famine and other destructive mishappenings moves the prices of
agricultural consumer goods upward. In addition to that, industrial production is
also affected as the supply of inputs falls short.
Both these factors exert
inflationary pressures.
7.
Low industrial production.
Various causes tend to affect the industrial
production negatively resulting in the short supply of consumer goods. Such

factors are strikes and lock outs, non-availability of factors of production, break
down of power supply, operation of law of diminishing return, etc. Fall in supply
will naturally increase the prices.
8.
Government Policies. Various policies of the government also help raising the
general price level in the country. For example wage policy fixing the wages of
workers working in specified industries; industrial policy, not allowing certain
industries to be in operation without license or providing excessive protection to
industries; export policy, making export of certain commodities obligatory, thus
leaving the domestic demand unsatisfied etc. affect the supply position of
industrial production unfavourably and price trend shows an upward move.
The cumulative effect of all the above factors sets in cost-push inflation in the economy.
Demand pull and cost push inflation in an economy go together and no demarcation line
can be drawn between the two. Both affects each other. In both the cases demand
exceeds supply and prices of factor inputs rise.
98
Effect or Consequences of Inflation

Inflation has its multi fold effects on different sections of the society and on the economic
activities.
Some effects are good and some others are quite undesirable. For the
economic development of the country and to different sections of the society. Modern
economists are of the view that a mild degree of inflation is not only desirable but also a
necessary condition for growth especially in developing countries where manpower and
natural resources are underutilized. A slow rise in prices may induce the investors to
undertake innovations and expand the level and scale of production. But, it is desirable
only as long as it is kept within controllable limits and is not allowed to gallop further.
Galloping inflation, certainly, has same serious consequences. The consequences of
inflation can be discussed under two sub-heads:
1.
Effects on production or on tempo of economic activities, and
2.
Effects on Distribution or on different sections of society or Social Ethics.
A.
Effects on Production or on Economic Activities.
As we explained in the above lines that a mild inflation serves as a topic for the economy
of the country and therefore, is a necessary condition for the growth of the economy. A
mild degree of inflation has some good effects.
With an increase in the price level, the profit margins of producers tend to widen. Rise in
price level also increases, the costs of inputs but the prices of inputs move slowly, as
compared to the prices of the final products. The producers thus, have a wider profit
margins. It encourages more investments in industries because investments in industries
shall be more attractive due to greater profit margins. It will lead to industrial progress of
the country as new and new industrial units will be promoted by the industrialists to earn
more profits. The industrial expansion boosts up the employment level. Expansion of
industrial base requires the employment of more and more labour and thus unemployed
manpower and resources are utilized.
But this favourable trend continues so long as the prices are rising at a slow speed and
state of full employment is not achieved. But as soon as the full employment point is
achieved, it becomes self-generating and creates uncertainty in the economic system. It
degenerates into runaway inflation of hyperinflation. This situation is not desirable for
99
investment and production activity and has the following adverse effects on the
productive activities of the economy.
(i)
The hyperinflation results in the fall of money value that discourages savings on
the part of general public. With the reduced savings, capital accumulation suffers
a serious setback, because of the increasing propensity to consume, rather than to
save something for future.
(ii)
Reduced capital accumulation shall affect the investment in productive activities

adversely that will consequently hamper the industrial production in the country.
(iii)
As inflation creates uncertainty in the economic activities, the production will be

affected adversely on this account. The entrepreneurs will be discouraged from
taking business risks in production.
(iv)
Runaway inflation also affects the pattern of production as the rise in general
price level disturbs the price relationship. The prices of some commodities go up
rapidly, while of some others, they move rather slowly and, of some, they remain
stationary or may even fall. There is, therefore, a diversion of resources from
sometimes of productions to others mainly from the essential goods industries
(which are low profit generating) to luxury goods industries (which are more
profit-prone industries). This results in further shortage of essential consumer
goods the common man, pushing the prices upward.
(v)
Inflation leads to hoarding of essential goods both by traders as well as the

consumers. Traders hoard stock of essential commodities with a view to earn
more profit in future because price will rise faster than the interest to be paid on
investment or with a view to selling scarce items in the black market or to create
artificial scarcity of essential goods, pushing the prices upward and resulting in
higher profits.
(vi)
Inflation gives stimulus to speculative activities on account of the uncertainty

generated by a continually rising price level. In order to earn more profits,
businessmen prefer to engage in speculative activities rather than to invest money
in productive activities.
(vii)
Inflation disrupts the smooth functioning of the price mechanism, thereby creating
all-round confusion in the economy. Artificial demands and supplies take place,
disturbing the forces of demand and supply.
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(viii) The worst effect of hyper-inflation is that, in course of time, it results in a flight
from domestic currency on account of its constant diminishing value. The people
lose confidence in their home currency and rush to buy foreign currencies of
stable value to safeguard their interest.
Thus, on production side, a mild degree of inflation, gives encouragement to produce
more till the stage of full employment but later on, production activities are discouraged.
B.
Effect on Society or on Distribution
A prolonged period of persistent inflation results in redistribution of income and wealth.

Inflation does not his all sections of society alike. Some gain but of inflation while some
others lose. These gains and losses results in redistributing the income and wealth
within the society. The effects of inflation on different sections of society may be
discussed as under:
1.
Debtors and Creditors. When inflation sets in, debtors as an economic group
tend to gain. During inflation, the value of money falls sharply but the debtor has
to repay the same amount of money he had borrowed few year hence in this way,
he returns less purchasing power to the creditor than what he actually borrowed.
Creditors, on the other hand, are losers during inflation because they receive
lesser purchasing power than what they had actually lent.
2.
Wage and Salary Earners. Wage and salary earners generally lose during
inflation. Although their wages and salaries also go up in the wake of rising
prices but wages and salaries generally do not rise in the same proportion in
which the price level or their cost of living rises. Thus the real value of their fixed
income falls and they are badly hit during inflation.
3.
Producers or Businessmen. Producers or businessmen gain during inflation as

the prices of their stock suddenly go up. It is a tonic for the businessmen and
producers. Though, the cost of production also goes up but prices rise at a faster
rate than the cost of production and thus, it results in higher profits.
4.
Investors. We can distinguish two types of investors:

(i)
Investors in equities (equity shares), and
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(ii)
Investors in fixed interest-yielding securities like bonds and

debentures. Inflation bestows favours on the former and is rather
harsh on the latter.
In case of former type of investors, equity
dividends increase as a result of increasing corporate profits during

inflation. On the other hand latter types of investors get fixed dividend
(on preference shares) or interest on bonds and debentures. Inflation
erodes the value of such dividend and interest with the rising prices.
Therefore, their interests are adversely affected.
The small middle class investors generally keep their savings in fixed deposits in
commercial banks or in their provident fund accounts maintained by their
employers through insurance covers. The value of their savings falls sharply on
maturity and therefore, household savings during inflation get discouraged.
People prefer to spend more of its income in purchasing consumption goods and
therefore, their will and ability to save are affected seriously. It badly hit the
process of capital formulation, in the absence of which rapid industrial
development cannot be expected.
5.
Farmers. Farmers gain during inflation. Like other producers, farmers gain
because of the time lag involved in the purchase of inputs and sale of output.
Moreover, the prices of farm products go up while the costs incurred by them do
not go up to the same extent. Again, farmers are generally debtors and as debtor,
they are to pay less purchasing power during inflation.
To conclude, we may say that inflation redistributes income and wealth but it increases
disparity of income and wealth in the society. It penalizes consumers, labours, creditors,
small investors and fixed income group while it rewards businessmen, debtors and
farmers.
9.9.6 MEASURES TO CONTROL INFLATION
Measures to check inflation pressures
Inflation is harmful to the economic development and the various sections of society and,
therefore, should be contained. There are three lines of action that can be adopted to
check inflation namely:
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1.
Monetary measures
2.
Fiscal measures, and
3.
Other measures.
1.
Monetary measures
Monetary measures are those measures of the government which aim at regulating the
money supply in an economy. Such measures directly hit the inflationary boom. As
Central Bank is the sole authority to control the money supply, this step is, therefore,
taken by the Central Bank of the country. Money supply, at any time consists of currency
and bank credit. Bank credit creates a proportionately larger share of money supply in an
economy. Therefore, the bent of monetary authority is to regulate the flow of bank
credit. The following monetary measures are popular curbing inflationary pressures.
(a)
Bank Rate Policy. Bank rate is a rate at which central bank of the country
accepts and lends money to the commercial banks. This rate effects the bankcredit issued by the commercial banks to businessmen. An increase in bank rate,
certainly, makes the bank-credit dearer because lending rate of interest is
increased accordingly. It will discourage borrowing by businessmen from banks,
resulting in a fall in the intensity of inflationary pressures in the economy.
Again increased interest rate, consequent upon the increase in bank rate, will
attract savings and induce people to save more rather than to spend money on
consumer goods.
The measure will reduce the supply of bank-credit and currency.
(b)
Open-Market Operations. Open market operations of the central bank are more
effective than the measures of bank rate policy. Under open market operations,
the central bank purchases and sells securities to curb deflation and inflation. As
an anti-inflationary measure, the central bank sells the government and other
securities to commercial banks and private individuals. The ultimate result is that
money flows from commercial banks to the central bank when banks and
individuals purchase these securities. It results in a fall in the cash reserves of the
commercial banks, ultimately therefore, an effective anti-inflationary weapon.
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The open market operations of the central bank generally increase the current rate
of interest also on two accounts.
(i)
The central bank invites the securities at higher rate of interest and
(ii)
Contraction in the reserves of commercial banks results in contraction of

credit. Thus higher rate of interest also helps in limiting the total (bankcredit and money) money supply in the economy.
(c)
Higher Reserves Requirements. The central bank, in order to reduce the money
supply in the economy, increases the limit of the reserve requirements of the
member commercial bank. The reserve is maintained by the central bank. The
transfer of money to the reserve will reduce the ability of commercial banks to
create credit.
(d)
Consumer credit control. Consumer credit means credit allowed by commercial

banks to purchase consumer items. During an inflationary boom, consumer credit
facilities are curtailed to the minimum by adopting any of the following three
ways:
(i)
By raising the minimum initial payment on specified goods.
(ii)
By extending the application of consumer credit control to a large number

of consumer goods, and
(iii)
(e)
By reducing the number of instalments or length of the paying period, etc.
Higher Margin Requirements. The central bank, adapting a selective credit

control method, may raise the margin requirements of loans. Banks generally,
advance loans against securities, keeping a fixed percentage of the value of
security in reserve. In other words, only a part of the value of security offered by
the loanee, is advanced to him as a loan. The higher the margin requirements, the
lower the amount of loan that the borrower can obtain from the bank. Thus,
fixing higher margin requirements limits the undue monetary expansion.
2.
Fiscal Measures
Fiscal measures are a part of the budgetary operations of a government. The principal
purpose of fiscal measure is reduce the public money from the market and thus to mop up
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the excessive purchasing power in the economy.
The major anti-inflationary fiscal
measures are:
(a)
Public Expenditure. A cut in the public expenditure i.e. expenditure by the state
authorities, can serve as an anti-inflationary tool. As expenditure on public works
involves more money in circulation, it should be kept under control.
But
reduction in public expenditure is not so easy as it is essential nature but nonessential expenditure can be reduced to the minimum. Another view of curtailing
public expenditure is that any drastic cut in public expenditure may actually lead
the economy in a slump.
This device to check inflation is not very effective because a cut in meaningful
expenditure is not possible at all.
(b)
Taxation. Any measure which reduces the disposable income in the hands of
general public in view of the limited supply of goods and services may prove antiinflationary. Taxes do this job very efficiently. The government, as an antiinflationary measure, may increase the rate of existing taxes and impose new
taxes on the commodities and services, so as to leave lesser money supply with
the public to purchase goods and services. The taxes to be used for this purpose
should be chosen very carefully. A choice should, however, be made in direct
and indirect taxes.
(c)
Public Borrowings. The main purpose of public borrowings is to take away from
the public the excessive purchasing power, which, if left free, would surely exert
an upward pressure on the price level. The large budget deficits, which are
mainly responsible for inflation, can be partly counteracted by covering the
deficits by public borrowing. If voluntary borrowing does not yield the desired
results, the government resorts to compulsory borrowing from the public.
(d)
Debt Management.
The existing public, debts should be managed by the
government in such a manner as to reduce the existing money supply with the
public and prevent further credit expansion. Anti-inflationary debt management
requires the repayment of bank held debt out of a budgetary surplus. This would
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check the power of commercial banks to en-cash securities and add to their
reserves for the purpose of credit expansion.
3.
Other Measures
These measures can be used to supplement monetary and fiscal measures. The important
other measures are:
(a)
Output Adjustments.
Increased production is the best antidote to inflation
because one of reasons of inflation is inadequacy of output. The following

measures may improve the situation.
(i)
As it is difficult to increase output because at a time of inflation, there is

supposed to be a state of full utilization of resources. It is, therefore,
suggested that if it is not possible to increase output as a whole, the output
of inflation-sensitive goods should be increased by shifting productive
resources from less sensitive goods to more inflation sensitive goods by
adaptive systems of priorities, regulated allocations and subsidies. For this
purpose, a re-allocations of factor resources is suggested to step up the
production of highly inflation sensitive goods such as food, clothing,
housing, etc.
(ii)
Large scale imports of consumer goods may ease the supply position of
essential commodities and may, therefore, minimize the inflationary
pressures.
(iii)
Vigorous campaign against monopolistic attempts to raise factor costs in

the strategic sectors of the economy should be launched.
(iv)
Efficient and satisfactory labour management relations should be

encouraged to remove bottlenecks which may impede production.
(b)
Wage-policy. Wages must be controlled to curb the inflationary pressures in the

economy. They are to be so fixed as not to increase the price level. This measure
can be undertaken only with the cooperation of trade unions by adopting the
following criteria:
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(i)
The wage-increase should be linked with the increase in productivity. If

this criterion is observed, higher prices will not increase the unit-cost and
the unit price.
(ii)
The wage-increase should be paid out of profit margins i.e. wage increase
should not be a reason for price increase.
(c)
Price Control and Rationing. It is a direct method to control price level. The
aim of price control is to lay down the upper limit beyond which the price of a
particular commodity would not be allowed to rise. To ensure the successful
functioning of price control, two pre-conditions are necessary:
(i)
The government should have sufficient stock of the commodity under

price control so that sufficient supply may be ensured, and
(ii)
The demand for the concerned commodities should also be kept under
control through rationing.
Under rationing, commodities are made
available to low-income groups at controlled prices. Price control cannot

be effected without rationing because the richer section shall be able to
purchase the major portion of the available stocks otherwise.
Thus the above steps taken simultaneously, may improve the situation a lot.
9.9.7 DEFLATION-CAUSES, EFFECTS AND MEASURES TO CONTROL
Meaning of Deflation
Deflation is opposite of inflation. It is a state where the money value is rising or the price
level is falling. According to Crowther Deflation is that state of economy where the
value of money is rising or the prices are falling. But every fall in prices cannot be
deflation. Sometimes, the fall in prices is caused by reasons other than contraction in
money supply. Obviously, such a fall in price level cannot be called deflation. Pigou has
defined the state of deflation as Deflation is that state of falling prices which occurs at
the time when the output of goods and services increases more rapidly than the volume of
money income in the economy. Thus, deflation occurs at a time when production of
goods and services is increasing at a faster rate that the money income.
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The definition given by Prof. Pigou gives an impression that fall in price-level is caused
by the contraction in money supply. But, it is wholly true. The fall in price level is not
only the result of the fall in money supply but it can also be the cause of contraction in
money supply. For example, if the fall in prices continues, the economy may not need as
much money in supply as before. Thus, the falling price level is both the result as well as
the cause of the fall in money supply. From this point of view, Einzings definition of
deflation is the best. According to him, Deflation is a state of disequilibrium in which
the contraction of purchasing power tends to cause, or is the effect of; a decline of the
price level.
A common phenomenon of deflation is falling prices. Therefore, in this study, we have
taken deflation as a situation in which general price level in an economy is falling or the
value of money is rising.
Causes of Deflation
A deflationary trend may be set in either of the following two situations:
(a)
When the aggregate demand of goods and services falls, and/or
(b)
When the supply of goods and services rises.
The various factors contributing to the fall in demand or the improvement in supply
position may be enumerated as follows:
(i)
Increase in Production: A rapid increase in production, surpassing the demand,

may cause a fall in general price-level. Over production may be the result of
measures taken to curb inflation, which remains uncontrolled at a particular point
and it steps into deflation.
(ii)
Anti inflationary measures: In a state of inflation government takes various

measures to check the inflationary trend in the economy, like higher bank rates,
open market transactions, higher taxation, and reduction in public expenditure and
so on. These anti-inflationary measure, if could not be controlled may lead to a
state of deflation because anti-inflationary measures include the measures which
may contract the money supply (real money and credit money) or may reduce the
disposable income of the people that result in the fall of general price level.
(iii)
Inflation: Inflation generates deflation. Inflation is state where price level rises
that induces the investors and businessmen to invest more and more in production
activities. Increase in production activities yield higher profits to investors and
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industrialists which again pushes up investment, production and profits.

Consequently, there would be a state of over investment and overproduction in
the economy which may push the price level downward. This situation may
discourage investment and production which may result in falling profit margins.
Any cut in investment and production programmes will leave an adverse effect on
the level of income and employment in the country and will breed deflationary
forces.
(iv)
Money shortage: when money supply is not sufficient to purchase the

commodities and services available in the country, the situation is known as
deflation. The price level in such a situation shall begin to fall. Money shortage
in the economy may be the result of two factors (i) note issuing authority may
decide not to increase the money supply in pursuit of its own objective, and (ii)
the commercial banks may choose to contract their deposits and credit.
(v)
Fall in disposable income: Disposable income means income which can be used
to purchase the goods and services. A fall in disposable income of the people will
further shrink the money supply and will lead to deflation. A fall in disposable
income may be due to either a fall in the national income itself or an increase in
taxation rates. Either situation may bring contraction in demand resulting in fall
in prices.
9.9.8 Effect of Deflation

The people in the economic world have become so accustomed to the rising prices that
we cannot even think of the disastrous effects of deflation. We can study the effects of
deflation under two sub-heads:
(a)
Effect on economic activity or on production.
(b)
Effect on distribution of income and wealth.
(a)
Effect on Economic Activity

Deflation has an adverse effect on the production, business activity and
employment. Deflation leads to depression in the economy because there is a
state of overproduction or in other words, a fall in demand. This situation leads to
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shrinking investment, shrinking production, shrinking employment of factor

services and shrinking income and profits. Once started, the deflationary process
is self-generating in character.
Continuous falling prices result in losses,
sometimes in heavy losses, forces many firms to close down. In the face of
declining demand for goods, firms are forced down to close down their operations
completely or leave part of their plant idle. Thus, production, income and profits
are curtailed and unemployment increased. Most of the workers lose their jobs
while others wages are cut down. Living conditions were appalling, and must
seem incredible. Thus, deflation affects the economic activities or the economic
adversely leaving everything to standstill. This is a serious defect of deflation.
(b)
Effect on Distribution of Income and Wealth

Deflation affects adversely, distribution of income and wealth too. Deflation is
reverse of inflation hence its effects are also reverse of inflation. All those social
groups who gain during inflation tend to lose during deflation. Conversely, those
groups who lose during inflation tend to gain during deflation. To be more
specific, speculators, businessmen, producers lose badly during this period
because cost of production does not fall as rapidly as the prices of the endproducts. Moreover, the demand of goods and services goes down due to lack of
purchasing power hence the value of stock fall sharply causing a loss in producers
and businessmen. Due to fall in demand and prices, profit margins dwindled
down to even zero. Likewise farmers also lose during deflation. The groups who
gain during deflation are consumers, creditors, fixed income groups, small
investors and wage earners because real income and wealth grows during this
period. Consumers can now purchase more goods and services due to fall in
prices. Real wages, salaries and interests go up because of increased purchasing
power of money because wages, salaries and interest, do not fall as rapidly as the
price level. Creditors are repaid with higher purchasing power and the interest
also has higher real value. But debtor during this period loses as he has to repay
more purchasing power in return to his debt.
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Though, deflation affects some of the groups favourably and some others
adversely. But, if think seriously, it will reveal that particularly all economic
groups are hit by deflation. As we have portrayed earlier that deflation results in
depression in economic activity. In worst sort of depression, employment is the
major casualty. As everybody is employed in one or the other job, so, none is
spared of deflation. The whole economy is shattered by deflation.
9.9.9 Measures to Check Deflation
Measures to check deflation take the same form as are used to check inflation viz
monetary, fiscal and other measures like low bank rate, open market operations, credit
control and increased margins should be used as anti-deflationary measures in such a way
that may be helpful in increasing the volume of bank credit. Expansion of bank credit
actually will increase the investment in productive activities and in turn; increase the
possibility of more employment. It will revive the economy.
The assumption in making use of monetary measures as anti-deflationary step is that the
expansion of bank credit will revive the situation. This assumption does not hold good in
such a situation because even when the commercial banks are prepared to advance loans
and issue credits to businessmen and producers to enable them to expand their investment
and production, it may be possible that they are not willing to accept credit for fear of
possible failure of their investments. Expanding credit is not sufficient unless steps are
taken to pull the demand so as to set in a sequential chain of higher demand, higher
production and higher income.
Thus monetary measures are not of much help in such a condition.
Fiscal Measures
Fiscal measures are a part of budgetary operations which reallocate the income and
wealth of the people through various budgetary exercises. Anti-deflationary fiscal policy
consists of increased public spending. Keynes and other later economists laid much
emphasis on public spending as an anti-deflationary tool to push up employment and
level of income in an economy. Deficit financing is one way of increasing expenditure
over tax revenue, thus increasing the money supply. On the one side, the government
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reduces the level of taxation so as to leave the larger disposable income with the public
and on the other hand, expanding more on public work programmes to increase the
money supply. The programmes include such schemes construction of roads, dams,
parks, etc. These projects can be financed by issuing fresh currency or borrowings from
banks. By this method, the government will:
(i)
Provide employment to those who are thrown out of job or are eligible jobseekers; increase the income of the people, raise the aggregate demand and thus
lead to increased employment. Thus, it leads to direct and indirect employment.
When once employment started rising, multiplier effect will come into play and
push up production and employment still further.
(ii)
Add to national wealth due to more production, investment and income. It will
induce savings resulting in capital accumulation gradually with the passage of
time, and
(iii)
Counteract the deficiency of private demand for goods and services by means of
an income in its own demand. The basic idea of fiscal policy is to expand
demand for goods or to counteract the decline in private demand. Fiscal policy is,
thus considered the most import policy for economic stabilization.
Other Measures
Other measures to control deflation include:
(i)
Price support programmes (to prevent prices from falling beyond a certain level);
(ii)
Provision of subsidies;
(iii)
Arrangement of easy availability of goods on hire purchase to stimulate demand;

and
(iv)
Keeping cost of production under controllable limits.
To sum up, the government should adopt such measures to counteract deflation as to
increase the aggregate demand on all counts. For this purpose, all types of measures
monetary and fiscal should be taken simultaneously. However, a major role is to be
played in this strategy by fiscal authorities.
INFLATION VS. DEFLATION
We have considered in length inflation and deflation and their effects on the national
economy and on the various economic groups in the society. Inflation is a state of rising
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prices and deflation, a state of falling prices. Both the situations are harmful to the
society as well as to the economy. Still inflation is considered to be the lesser of the two
evils. In the words of Keynes, Inflation is unjust, deflation is inexpedient. Of the two,
deflation is worse. Though these two situations are thought to be just opposite to each
other, however, it is not so. Inflation is a state of rising prices unaccompanied by
increase in employment whereas deflation is a state of falling prices accompanied by
increasing unemployment.
Thus, these two terms are not symmetrically opposites.
Deflation hits the society the most. Thus, it is correct to say that both the situations have
adverse effects, but of the two deflations is perhaps worse. Now we shall consider these
two situations:
Inflation is unjust
Inflation may be considered unjust on the following grounds:
(i)
Inflation results in an invisible taxation. During inflation, general price level

goes up, that deprives the consumers of their purchasing power. Consequently
they are not able to purchase goods and services to the extend desired, though
they have more money income. Inflation, thus, diverts the goods and services
meant for public consumption to the government which is quite unjust and
inequitable.
(ii)
Inflation brings a sort of artificial prosperity in the society. The price level
goes up and everybody in the society is getting richer.
Thus, there is nothing to choose between the two but still inflation is, undoubtedly better
than deflation on the above grounds. Keynes, therefore wanted to avoid deflation on all
costs. But, it does not imply that the advocated inflation as a monetary policy, of full
employment should be to aim at economic stabilization at the level of full employment.
Distinguish between:
(a)
Inflation and Reflation
(b)
Deflation and Disinflation
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(a)
Inflation and Reflation

Inflation is a state of situation when money supply in the economy is increased in
excess of its need to purchase the goods and services available. It disturbs the
cost-price relationship.
The prices rise rapidly.
Reflation is an inflation
deliberately undertaken to relieve a depression.

Price rise is a common phenomenon in both the situations. But every price rise
cannot be named does not cause inflation. Generally when deflation is carried to
its extreme limit and prices fall down to the lowest limit, then the government
resort to anti-deflationary measures to protect the economy from its serious
consequences. The government increases money supply with a view to push up
the economy. The situation of unemployment is worse under deflation. Increase
in money supply will increase demand, production and prices and consequently
employment.
Price rise is generally assumed to be the situation of inflation but every price rise
is not inflation. Mr. Keynes distinguishes two types of rise in prices:
(a)
Rise in prices accompanied by increase in the level of output; and
(b)
Rise in prices not accompanies by increase in the level of output.
Thus, if the prices are rising as a consequence of steps taken to combat deflation,
it will increase production and demand. As there exists a high degree of
unemployment. Increase in production will increase the level of employment.
Money supply will be increased. An increase in the aggregate demand will be
accompanied by (a) rise in the volume of goods and services produced in the
economy and (b) a rise in the general price level. This type of rise in prices
(which accompanies with increased production) is known as reflation. The price
rise in such a situation is very mild and up to the level of full employment, prices
will not increase rapidly. G.D.H Cole has therefore defined reflation as Inflation
deliberately undertaken to relieve a deflation.
But, if prices continue to rise any further, after the level of full employment has
been achieved, it will not be accompanied by any increase in production and this
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situation is called inflation. Under inflation prices rise but production remains
static. This situation is harmful to economy and to various economic groups.
Thus, inflation and reflation seem alike because price rise is common under both
these situations. But still there are certain notable differences between these two
situations as under:
(i)
Inflation is the cause and effect of increased money supply and can also be
due to natural causes on which government has no control. Reinflation, on
the other hand, is always deliberate on the part of the government to
relieve of the situation of deflation and it is never due to natural causes.
(ii)
Reflation invariably occurs in the boom stage of the trade cycles or in

other words, before the point of full employment whereas inflation,
generally, occurs in the recovery stage of trade cycles, i.e. after the point
of full employment is achieved.
(iii)
Prices, under reflation, rise slowly and steadily because the pressure of
price-rise is offset by the increase in production.
Under inflation,
production does not increase with the increase in prices hence the prices
increase very rapidly.
(iv)
Inflation, if allowed to continue without any proper check, it will ruin the
economy of the country whereas reflation brings about planned
improvement in the already shattered economy.
(b)
Deflation and Disinflation

Deflation is a situation of falling prices. But every fall in prices is not deflation
just every increase in prices is not inflation. Deflation according to Elinzing is a
state of disequilibrium in which the contraction of purchasing power tends to
cause, or is the effect of, a decline in the price level. Thus, if disequilibrium in
the fall in prices and fall in output occurs, it is a state of deflation. To be more
specific, if the fall in price level is accompanied by a dis-proportionate fall in the
level of output, it is a stage of deflation.
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Conversely, if the fall in prices does not bring about any fall in the level of output,
income and employment in the economy, it is known as disinflation.
It is
generally caused when government takes anti-inflationary measures to bring the

prices of goods and services down not resulting any downward change in output.
Thus, just like reflation, it is also a deliberate attempt of the government towards
checking inflationary pressure in the economy. If, with a fall in prices, the
economy moves towards the point of full employment level, this fall in prices
may be characterized as disinflation up to the point of full employment. If the
price level continues to fall any further i.e below the full employment level, it is
deflation. This fall in prices will be accompanied by a fall in the level of output.
The fall in price level is common in both the situations but still, they differ in
many respects. The bases of difference between these two situations are the same
as they are between inflation and reflation (given in the above lines).
To sum up, inflation occurs when prices move upward even after the point of full
employment is achieved and deflation occurs when prices fall even after the point
of full employment is reached. Thus, inflation and deflation are opposite to each
other.
Reflation and disinflation, both the situations are the result of the
deliberate attempts of the government to bring the prices to a level that may
correct the deflationary or inflationary pressures. Thus, reflation and disinflation
are reverse to each other.
a. Stagflation
b. Phillips curve
(a)
Stagflation
Stagflation is a new type of situation. It is a name given to a situation where
inflation of prices and stagnation of economic activity exist side by side. Under
such a situation the general price level is high and there are inflationary pressures
all round but still in spite of that, there are recessionary trends in certain
industries, particularly construction industries. This type of situation emerged in
the post war period particularly since the Sixties and the whole world is in its
grip.
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According to Keynes inflation starts as soon as the level of full employment in the
economy is reached. If prices arise any further and the inflation steps into hyperinflation, its bad effects began to appear. The real income of the people began to
fall and they prefer to spend money rather than to save it for future and therefore,
it pulls down the demand of some non-essential items. Upto a point, demand,
under inflation, goes up and production increases, but beyond that point, the
demand becomes stationary or starts falling and consequently, the production in
some industries is halted or even reversed. This happens in certain non-essential
industries because inflation distorts the cost price relationship and the people
change their priorities. They spend first to necessities and if purchasing power
remain they buy such items.
Inflation leads to fall in saving and capital accumulation. Increase in private
investment may not take place because (a) investors may be afraid of future, and
(b) there is decline in demand at the height of inflation. In fact, the decline in
consumer demand and private investment will reinforce each other and create a
deflationary situation. Further, an excessive price-rise may affect the export
adversely and may bring in slump in export industries which will be passed on to
other industries as well. It is thus possible that both inflationary and deflationary
pressures exist in the economy side by side. The existence of an economic
recession at the height of inflation has been called as stagflation. (Stagnation +
Inflation).
It is very difficult to check the situation of stagflation for monetary authorities.
Any step taken to fight inflation accentuate recession, and measure to check
recession strengthen inflation again. The world stands today between the devil
(of inflation) and the deep sea (of unemployment).
(b)
Phillips Curve
The Phillips curve has acquired considerable significance in the analysis of an
inflationary situation. The curve establishes a relationship between the rate of
wage increase and the rate of unemployment. The curve is named after A.W.
117
Phillips who made a pioneering study of the relationship between the percentage
of money wage increase and the percentage of unemployment. The curve is
shown below:
Y
P
Rate of Unemployment
The curve slopes downward from the left to the right and indicates an inverse
relationship between the rate of money wage increase and the rate of
unemployment. It pin points that if wage-push inflation is to be avoided and noninflationary price stability is to be achieved, there would be a high degree of
unemployment. It implies that for higher rate of employment, wage push is
necessary, and that wage-push is not inflationary in character if it is offset by the
increase in productivity. The conclusion is clear. If the wage push inflation is to
be avoided, the society must accept a high rate of push unemployment.
Conversely, if there is a widespread unemployment in the society, wage increase
cannot push to inflation. Because in such a situation, the trade union will prefer
to get employment for their unemployed members rather than to agitate for higher
wages.
Thus, higher wages cannot be claimed until there is a state of full
employment. Hence, the existence of high rate of unemployment is the sine quo
non for the avoidance of high rate of inflation in a capital society in terms of the
Phillips curve. It should, however, be noted that every increase in the rate of
money, wages is not inflationary in character if an increase in money wages is
accompanied by an equivalent increase in productivity.
118

Identify the most common form of inflation found in developing economy like
Kenya? Give reasons for your answer,
Discuss the causes of Demand pull inflation
Differentiate between inflation and deflation, which one is just to an economy and
why?
Explain the measures to control inflation,
9.9.11 Self-Test Question

Discuss the socio-economic consequences of the high and rising price level in
Kenya today,
Zimbabwe was brought down to its knee due to un tamed inflation which utterly
destroyed all its valuable resources, as a student of monetary policy, advice the
Zimbabwean Monetary authority on the way to revive/jam start the economy,
Explain the usefulness of inflationary - gap in analysing a process of inflation,
When Wiiliam Ruto, the current deputy president was the minister for Agriculture
(2008-2009) the Kenyan economy experienced deflation for the first time, discuss
the factors that led to this,
9.9.12 Summary
In summary, we have learnt that:
Inflation creates uncertainty in the economic activities,
Inflation can be controlled with the use of both monetary and fiscal measures,
Inflationary gap exist when there is excess of anticipated expenditure over available output at
base prices,
Inflation is unjust ,

The students can read further on theories of inflation
119
10.0 LECTURE TEN: THEORY OF INTEREST
10 .1 Introduction
This lecture looks further into taxation of income from other sources besides employment
income. These incomes include rental income and investment income in the form of
dividend and interest income. Thereafter we will look at computation of taxable income
for an individual who is employed and receives income from other sources.

At the end of this lecture, the student should be able to:
Define interest
Understand the theories that explain why interest is paid
Explain how the interest rate is determined
Criticize the theories relating to why interest is paid and how interest is paid
10.3 Lecture Outline

10.10.1 Why interest is paid
10.10.2 Determination of the rate of interest
10.10.3 Critics of the theories
THEORIES OF INTEREST
Theories of interest are of two kinds:
(a)
Those theories which relate to the problem why interest is paid.
(b)
Those theories which relate to the problem how rate of interest is determined.
10.10.1 WHY IS INTEREST PAID?

The following theories explain why interest is paid:
1.
Marginal Productivity Theory

According to this theory, interest is paid due to the fact that capital is productive.
With the help of capital, it is possible to increase the production of commodities
120
to a great extent. Capital is productive in the sense that labour assisted by capital
produces more than without capital. For example, a fisherman can catch more
fish with a net than without it.
However the more capital one employs the more and more productive it becomes.
Hence the capital owners seek to get higher prices (Interest) for lending out higher
capital.
Critics
If people were willing to lend unlimited amounts of money without interest, a business
would expand up to a point where the falling price of the product would simply cover
other charges. However investors are only willing to lend a limited amount of capital at a
time.
2.
Abstinence or Waiting Theory

According to this theory, saving involves a great sacrifice or abstinence, because
saving is an act of abstaining from the consumption.
Since to abstain is
inconvenient, it is necessary to pay some reward to encourage abstinence. This

reward is actually called interest.
The idea of abstinence was criticized by Prof. Marshall on the basis that rich
people save without any pain or inconvenience.
Thus Marshal used the term waiting instead of abstinence. According to him,
saving implies waiting.
When a person saves, he does not refrain from
consumption for ever; but he has to wait. Since most people do not like to wait,
an inducement is necessary to encourage this postponement of consumption and
interest is this inducement. For this reason savers are paid interest by banks.
Critics
This theory has a considerable element of truth in it, but it does not clearly
analyse the forces acting on the demand side of capital.
3.
Austrian Theory:
It was advanced first by John Rae in 1834. But it was presented in the final shape
by Prof. Bohm Bawerk of the Austrian School of Thought. According to this
theory, interest arises because people prefer present goods to future goods. This
121
is due to the reason that present wants are felt more seriously as compared to
future wants hence present satisfaction is preferred to future satisfaction. Interest
is the discount which must be paid in order to induce people to lend money or
postpone present satisfaction to a future date.
Why do people prefer present satisfaction to future satisfaction? Three reasons
are given for this fact.
4.
1.
The future is uncertain
2.
Present wants are felt more seriously than the future wants.
3.
Present goods possess a technical superiority over future goods.
Liquidity Preference Theory

According to Keynes, the rate of interest is a reward for parting with liquidity.
Keynes believed that people had a preference for liquidity. In other words, people
have a demand to hold money in cash form.
In order to induce people to part with liquidity, they must be paid a reward in the
form of interest.
The rate of interest depends upon the degree of liquidity
preference. The greater the liquidity preference, the higher the rate of interest and
vice-versa.
10.10.2 HOW IS RATE OF INTEREST DETERMINED?
The following theories explain how interest rates are determined:
1.
Classical Theory
2.
Loanable Funds or New Classical Theory
3.
Keynesian or Liquidity Preference Theory
All these theories of interest seek to explain the determination of the rate of interest
through the equilibrium between the forces of demand and supply. These are explained
as under:
1.
Classical Theory
The classical theory of interest is also known as the real theory of interest.
According to this theory, the rate of interest is payment for abstinence or waiting
or time preference. The rate of interest, in this theory, is determined by the
demand for capital and supply of savings.
122
The demand for capital goods comes from the firms which desire to invest.
Capital goods are demanded because they can be used to produce consumers
goods. If the demand for consumers goods is high, demand for capital goods will
also be high.
Capital like other factors of production has marginal revenue
productivity.
If demand for capital goods is high, its marginal revenue
productivity will be lower and vice versa.
Therefore, the marginal revenue
productivity curve of capital slopes downwards towards the right.

According to the classical theory, money which is to be used for purchasing
capital goods is made available by those who save from their current incomes.
Savings involve the element of waiting for future enjoyment of savings. But
people prefer present satisfaction of goods and services to the future enjoyment of
them. Therefore, if people are to be persuaded to save money and to lend it to the
entrepreneur, they must be offered some interest as reward. If reward for savings
is higher, individuals will be induced to save more and vice-versa. Thus the
supply curve of capital slopes upwards toward the right.
The rate of interest is determined by the interaction of the forces of demand for capital
and the supply of savings. The rate of interest at which the demand for capital and supply
of savings are in equilibrium will be determined by the market. The way in which the
rate of interest is determined by the demand for investment and supply of savings is
shown in the following diagram, where SS is supply curve of savings and DD is the
INTEREST
demand curve of savings to invest in capital goods.
R
D
O
M
123
CAPITAL
In the above diagram, the demand for investment and supply of savings are in
equilibrium at OR rate of interest where the curves intersect each other.
OR is
equilibrium rate of interest and OM is equilibrium amount of money which is borrowed

and invested. If any change in the demand for investment and supply of savings comes
about, the curves will shift accordingly and, therefore, the equilibrium rate of interest will
also change.
Criticism by Keynes
This theory has been criticized by Keynes on various grounds.
1. He pointed out that classical theory of interest is based upon the assumption of full
employment of resources. According to this theory, an increase in the production of
one thing must mean the withdrawal of some resources from the production of other
things. If investment is to be increased, this can only be done if resources are
withdrawn from the production of consumer goods. But this assumption is not based
on real fact because there may be unemployment in the country and it is possible to
find out unemployed resources and, in this case there is no need for paying people to
abstain from consumption.
2. According to the classical theory of interest, more investment can take place only by
decreasing consumption but a decrease in demand for consumers goods is likely to
decrease the incentive to produce capital goods and therefore, it will affect investment
adversely.
3. By assuming full employment, the classical theory has neglected the changes in the
income level. According to Keynes, equality between savings and investment is
brought about not by changes in rate of interest but by changes in the level of income.
4. The classical theory, as pointed out by Keynes, is indeterminate. Position of the
savings schedule depends upon the income level. There will be different savings
schedules for different levels of income. Thus, we cannot know what the rate of
interest will be unless we know the income level. In this way, the classical theory
offers no solution and it is indeterminate.
124
2.
Loanable Funds Theory:
Loanable funds theory may be known as new classical theory. It was presented by
Swedish Economist, Robertson. According to this theory, rate of interest is determined
according to the forces of demand for and supply of loanable funds.
The supply of loanable funds is derived from four basic sources, namely:
(a)
Savings,
(b)
(d)
Disinvestment.
(a)
Savings (S)
Dishoarding
(c)
Bank credit, and
Saving by individuals constitutes the most important source of loanable

funds. At a higher rate of interest, savings will be greater and vice-versa.
(b)
Dishoarding: (DH)
It is another source of loanable funds. Individuals may dishoard money
from the hoarded stock of the previous period. At higher rates of interest,
more will be dishoarded and vice-versa.
(c)
Bank Credit: (BM)

The banking system provides a third source of loanable funds. Banks by
creating credit can advance loans to the businessmen. The banks will lend
more money at higher rates of interest that at lower ones.
(d)
Disinvestment: (DI)
Disinvestment is the opposite of investment and takes place when due to
some reasons the existing stock of machines and other equipment is
allowed to wear out without being replaced or when the inventories are
drawn below the level of previous period. When this happens, the part of
the revenue from the sale of product instead of going into capital
replacement flows into the market for loanable funds.
By the later summation of the four curves S, DH, DI, BM, we get the total supply
curve of loanable funds which slopes upward to the right showing that a greater
amount of loanable funds will be available at higher rates of interest and viceversa.
125
The demand for loanable funds mainly comes from three fields, (i) Investment,
(ii) Consumption and (iii) Hoarding.
Demand for loanable funds for investment purposes by business firms is the most
important element of total demand for loanable funds. The price of the loanable
funds required to purchase the capital good is obviously the rate of interest. It
will pay businessmen to demand loanable funds up to the point at which the
expected rate of return on the capital goods equals the rate of interest.
Businessmen will find it profitable to purchase larger amounts of capital goods,
when the rate of interest declines. Thus, the demand for loanable funds curve for
investment purposes slopes downwards to the right. This is represented by the
curve I.
The second big demand for loanable funds comes from individuals who want to
borrow for consumption purposes. Individuals demand loanable funds when they
wish to make purchases in excess of their current incomes and cash resources.
Lower rates of interest will encourage some increase in consumer borrowing.
Demand for loanable funds for consumption purposes is shown by the curve C
which also slopes downwards to the right.
Finally, the demand for loanable funds may come from those who want to hoard
money. Hoarding signifies the peoples desires to hoard their savings as idle cash
balances. Demand for hoarding is represented by curve H. The demand for
hoarding money also slopes downwards to the right.
According to loanable funds theory, the rate of interest will be determined by the
equilibrium between total demand for loanable funds and total supply of loanable
funds shown in the following diagrams:
126
INTEREST
DH
DI
S
BM
LS
C
H
LOANABLE FUNDS
LD
In the above diagram, LS is the total supply curve of loanable funds. It has been
derived by the later summation of the saving curve (S), dishoarding curve (DH),
Bank total credit curve (BM), and disinvestment curves (DI). Total demand curve
for loanable funds is LD which has been found out by the later addition of the
curves, I, C and H which show, respectively, the demand for loanable funds for
investment, consumption and hoarding purposes. The curves LD and LS intersect
each other at point E and in this way, the equilibrium rate of interest is OR.
3.
Keynesian theory:
Keynes has presented a theory of interest determination. According to him,
interest is a monetary phenomenon in the sense that the rate of interest is
determined by the demand for and the supply of money. The rate at which
interest will be paid depends on the strength of the preference for liquidity in a
relation to the total quantity of money available to satisfy the desire for liquidity.
Keynes says that interest is the reward for parting with liquidity for a special
period. Hence, greater the desire for liquidity, higher the rate of interest and viceversa. Liquidity preference means the desire to hold on liquid cash by people.
Liquidity preference of a particular individual depends upon several
127
considerations. Individuals keep money in liquid form due to the following three
motives:
1.
The transaction motive
2.
The precautionary motive
3.
The speculative motive
As regards the supply side of Keynesian theory, supply of money depends on the
decisions of the monetary authority.
By supply of money, we mean amount of money in circulation or quantity of
money which is available in the country. According to Keynes, supply of money
is not affected by the rate of interest and it remains constant in the short period.
Rate of interest may be higher or lower, but the supply of money in the short run
remains constant. Supply of money curve remains parallel to Y-axis. Supply of
money may consist of currency notes, coins, and gold reserves.
According to Keynesian theory, rate of interest is determined
at that point where
S
demand for money is equal to supply of money or in other words where liquidity
curve and supply curve intersect each other.
It is shown in the following
diagrams
INTEREST
L
E
R
0
S
QNTY OF MONEY
In the above diagram, LL is liquidity preference curve and SS is supply of money

curve. These two curves intersect each other at point E where demand for money
and supply of money both are equal to OS and rate of interest is OR. If liquidity
128
curve moves upwards, supply of money remaining the same, rate of interest will
rise and vice-versa. Similarly, demand for money remaining the same, if supply
of money increases, rate of interest will fall and vice-versa.
Keynesian theory has also been criticized on the following grounds:
i) It has been pointed out that rate of interest is not purely monetary
phenomenon. Because real forces like productivity of capital also play
an important role in the determination of rate of interest. Keynes makes
the rate of interest independent of the demand for investment funds. In
fact, it is not independent.
ii) Keynesian theory of interest like the classical and loanable funds
theories is indeterminate. According to this theory, rate of interest is
determined by the speculative demand for money, and the supply of
money available in the country. Given the total supply of money we
cannot know how much money will be available to satisfy the
speculative demand for money unless we know the transaction demand
for money and we cannot know the transaction demand unless we first
know the level of income. Thus Keynesian theory is also indeterminate.
4. Hicks and Hansens Formulation
Modern economists like Prof. Hicks and Prof. Hansen have made a formulation between
the various theories and have given an adequate and determinate theory of interest.
Hicks and Hansen stated that rate of interest is determined by the following four factors
mutually.
(i)
Demand for capital
(ii)
Savings
(iii)
Demand for money
(iv)
Supply of money
129

1. Discuss the sources of loanable funds theory,
2. Explain the following terms as used in the loanable funds theory of interest,
i.
Disinvestment,
ii.
Dishoarding,
3. In your own words, explain how Bank credit is used as an alternative source of bank funds,
4. Bring out the difference between the Austrian and the waiting theory of interest,

1. According to Austrian theory, present goods are superior to future goods discuss this
statement.
2. With a suitable illustration, explain the shift in the market rate of interest,
3. Critically analyse the Keynesian theory of interest,
4. Explain the relationship between capital goods and consumer goods,
10.10.5 Summary
In summary we have learnt that:
Interest is reward for parting with liquidity, the higher the liquidity the higher the interst
A market equilibrium is not stable but will change depending on the active market force
( Demand for loanable fund or supply of capital)
Keynesian theory holds that interest is a monetary phenomenon in the sense that the rate of
interest is determined by the demand for and the supply of money.

The students can read further on the general theory of interest and money and the IS and LM (
The Product and the Money market) functions
130
10.0 LECTURE ELEVEN. CREDIT CREATION AND CONTROL
11.1 Introduction
The central bank employs a number of tools to regulate or control the credit created by
the commercial bank so as to make the economy move in the desired direction. The
principal methods of credit control generally used by a central bank can be classified as
(i) Quantitative or general methods, and (ii) Qualitative or selective methods.
The
quantitative measures are intended to regulate the volume of credit created by the
banking system in general, according to the needs of the economy without devoting any
though to the uses to which, it is to be put.
Qualitative or selective measures, on the
other hand, are designed to regulate the flow of credit to specific uses. We shall now
explain the various quantitative and qualitative methods of credit control.

Explain the process of credit creation and control
Distinguish between Qualitative and Quantitative credit controls
List and explain the limitations of Quantitative credit control
Describe the effectiveness of Qualitative as a technique of credit control

11.11.1 Quantitative Credit control
11.11.2 Techniques of Quantitative credit control
11.11.3 Effectiveness and Limitations of the techniques
11.11.4 Qualitative or Selective credit control
11.11.5 Techniques of Qualitative or Selective credit control
11.11.6 Effectiveness and Limitations of the Qualitative technique
131
11.11.2Quantitative Methods of Credit Control

Some of the important quantitative methods of credit control are as follows:
1.
Bank Rate or Discount Rate Policy. Bank rate refers to the rate at which the
central bank is prepared to rediscount the bill of commercial banks or lends
money to commercial bank. According to Prof. Spalding, the minimum rate
changed by the bank for discounting approved bills of exchange. As the central
bank is bankers bank and the lender of the last resort hence commercial banks
have privilege to borrow funds from the central bank as and when they need funds
either by rediscounting the bills of exchange already discounted by commercial
banks or against security of such bills or other approved papers. The minimum
rate at which the central bank is ready to lend is bank rate. The bank rate and the
rate of interest are positively correlated and move in the same direction. The
Bank-rate is the rate at which the central bank lends to the commercial bank and
rate of interest is the rate at which the commercial banks lend money to their
customers. Both these rates are inter-related. If bank rate is changed (increased
or reduced), the rate of interest will also change in the same direction. The
change in rate of interest corresponding to change in bank rates will make the
credit dearer or cheaper that may encourage or discourage the borrowers to
borrow funds from commercial banks.
The central bank, by effecting a change in the bank rate can effectively control the
supply of bank credit.
If the economy is under inflationary pressures, it may be desirable to raise the bank rate.
Any increase in bank rate would bring an increase in the rate of interest charged by the
commercial banks on their lending. It means, the bank credit would become dearer, and
the borrowers from commercial banks would be discouraged from seeking loans from
banks. It would, hence reduce the credit supply and consequently the total money supply
in the economy. It would, thus, receive the economy of inflationary pressures. In the
same way, a fall in bank rate may increase the total volume of bank credit and total
money supply and hence relieve the economy of the deflationary pressures.
132
Assumptions of Bank Rate Policy. The bank rate policy of credit control may yield the
desired results, if the following conditions prevail.
(i)
Flexible Economy The economy structure of the economy must be

flexible enough so that the change in the bank rate may be fully reflected
in the changes in wages, rent, prices, employment and production etc.
(ii)
Change in Interest Rate The change in bank rate must bring about a
change in the interest rate in the same direction. It requires a completely
organized money market.
(iii)
Psychology of Investors The success of bank rate policy also depends

upon the psychology of the investors. It is therefore, necessary that an
increase in bank rate must discourage the investors from taking loans from
commercial banks and any fall in bank rate must encourage them.
(iv)
Other Factors Other factors that make the bank rate policy successful
are (a) commercial banks have sufficient eligible securities to rediscount
or pledge, and (b) commercial banks keep only the minimum cash reserve
required for their routine transaction and for additional reserves, they
depend upon the central bank.
Effectiveness of Bank Rate Policy The bank rate is a significant tool in the hands of
the central bank.
Significance of bank-rate policies:
(i)
It represents the basis at which the commercial banks get credit from the
central bank.
(ii)
It indicates the rate at which the public is able to obtain accommodation

from commercial banks. In any case, the rate of interest shall not be lower
than the bank rate.
(iii)
It influences greatly the psychology of the investors and therefore, the

bank rate policy of the central bank has great psychological value.
133
Limitations of Bank Rate Policy

(i)
Non-Existence of Conditions The necessary conditions for the success

of bank rate policy do not exist in underdeveloped economies. There is no
immediate effect and close and definite relationship between the bank rate
and the rate of interest. It has actually no psychological influence on
investors except on speculators. Other conditions are also not in existence
in a developing economy.
(ii)
Entrepreneurial Activities not Sensitive The sound assumption and

therefore, it is not necessary that a change in bank rate shall necessarily
have influence on entrepreneurial activities.
With the exception of
speculative activities, real entrepreneurial activities are not much sensitive

to change in bank rate as assumed under by bank rate policy. These
activities are influenced more by business prospects than by changes in
rates of interest.
(iii)
Non-effectiveness of Bank Rate Policy The bank rate policy is more

effective as an anti-inflationary measure rather than as an anti-deflationary
measure because, lowering of bank rate during deflation fails to generate
the tempo of economic growth. During inflation, entrepreneurs are very
much reluctant to borrow and invest funds in economic activities due to
low demand and low profits.
(iv)
Internal and External Effects of Bank Rate Policy There is conflict

between internal and external effects of bank rate policy. If bank rate is
raised to control the high general price level in the country, it may attract
short term foreign funds into the country as the deposit and lending
interests would go up thereby endangering the success of the central
banks anti-inflationary policy.
(v)
Non-Dependence of Commercial Banks One of conditions for this

success of bank rate-policy is the dependence of commercial banks on the
central bank for rediscounting facilities. It has, therefore, been assumed
under bank rate policy that commercial banks do not have sufficient cash
reserves to meet additional credit requirements. But, in recent years,
134
commercial banks have sufficient liquid resources and now they do not
approach to the central bank for financial accommodation in normal times.
(vi)
Impersonal Nature of Bank Rate Policy A serious limitation of bank

rate policy is that bank rate affects each and every type of activity whether
speculative or entrepreneurial in character. Suppose, if the bank rate is
raised in order to curb speculative activities, the resulting rise in interest
rates will discourage genuine productive activities as well.
Open Market Operations The open market operations means purchase and
2.
sale of government and other eligible securities by the central bank in order to
check the flow of credit. The securities to be purchased and sold in open market
may be government securities, equity shares of companies, gold or foreign
exchange, bills of exchange etc. M.H. De Kock puts open market operations of
the central bank as may be held to cover the purchase or sale by the central
bank in the market of any kind of paper in which it deals, whether
government securities or other securities of bankers acceptance or foreign
exchange generally. This method of credit control was very much prominent in
England in 18th and 19th centuries. But now, it is being adopted by the central
banks of all the countries in the world.
Open market operations are used to influence the flow of credit in two ways.
i.
by influencing the cash reserves of the commercial banks, and
ii.
By influencing rate of interest.

(a)
The Open Market Operations Influence the Cash Reserves of the

commercial banks hence they control their credit creation power. These
operations have anti-inflationary as well as anti-deflationary effects.
When the economy experiences inflationary trend, the central bank sells
the government securities to commercial banks, and other individuals,
leading to the flow of money from commercial banks and individuals, to
the central bank. The result is that cash reserve as well as deposits of
135
commercial banks would fall which, in turn, reduce their credit creation
power.
Similarly, when the economy experiences deflationary pressure, the
central bank began to purchase the government securities and other papers
from commercial banks and other individuals in the open market and thus,
releases cash resulting in the increase of cash reserves and deposits with
the banks enabling them to create more credits. In this way, the purchase
and sale of securities by the central bank increases or decreases the cash
reserves and the money supply that directly affects the credit creation
power of commercial banks.
(b)
Affecting the rate of interest in the economy. When the central bank
sells securities, it contracts credit and money supply in the economy
leading to an increase in the interest rate that makes the credit costlier. It
will thus dampen the demand for credit.
Conversely, purchase of
securities by the central bank increases money supply and consequently

the credit creation power of the commercial bank. Easy availability of
credit may result a fall in the rate of interest that would expand credit.
Conditions for the Success of Open Market Operations
(i)
There must be a continuous demand and supply of various

securities.
(ii)
The money market must be fully developed and organized so that

securities may be sold or purchased at any time.
(iii)
The cash reserve of the commercial banks must have direct and
immediate bearing of the open market operations of the central
bank.
(iv)
The lending policy of the commercial banks must remain

unaffected by these operations.
(v)
The central bank must have unlimited power to purchase and sale
of securities.
136
(vi)
There must not be frequent fluctuations in the value of government

securities.
Limitations of the Policy of Open Market Operations

(a)
No well-developed Security Market. One of the conditions for

the success of open market operations is the existence of developed
and well-organized security market.
But in undeveloped or
underdeveloped countries, such security market does not exist.

Hence these operations have not been as successful in under
developed countries as they are in developed countries.
(b)
Non-operation of Extraneous Factors The open market

purchases or sales transactions of securities of the central bank do
not always increase or decrease the quantity of money in
circulation and the cash reserves of the commercial banks, as a
number of disturbing factors may be operating in the economy
simultaneously. It may be possible that when the central bank
injects money into the economy by the purchase of securities, it
may;
(i) go out of country, due to an unfavorable balance of payments,

(ii) be hoarded by the public, a part of the additional cash put into circulation. Similarly,
the effect of sale of securities on cash reserves of commercial banks will be neutralized
by factors like (i) inflow of capital due to favorable balance of payment, or (ii)
dehoarding of money.
(c)
Maintenance of a Definite cash reserve ratio. If the commercial

banks maintain the cash reserves in excess of the minimum fixed
ratio or maintain other types of secret reserves. The policy of the
open market operations will lose its effectiveness. If the central
bank starts selling securities with a view to squeeze credit, the
commercial banks will purchase these securities with their
137
excessive cash reserves and therefore, their credit creation power

will not be affected, as desired by the central bank.
(d)
Unwillingness of Borrowers.
The policy of open market
operations may not succeed if due to some general economic and

political conditions, the borrowers are not willing to borrow funds
from the commercial banks. Such conditions may be economic or
political uncertainties such as recession or unfavorable trade
policies etc. In such conditions the borrowers will not be willing
to borrow funds even if they are available at cheaper rate of
interest. In such cases, change in cash reserves with the banks
hardly influence the credit needs and therefore, the open market
policy will not succeed in its desired goal
(e)
Adequate Stock of Securities. There is one assumption for the

successful operation of the policy of open market operation that the
central bank of the country must possess an unlimited stock of
government securities or in other words, it must have an unlimited
power to purchase and sale sell securities in the market. If the
stock of securities is limited, the policy cannot operate
successfully.
(f)
No Direct Access to the Central Bank. The commercial banks

must not have direct access to the central bank for their credit
needs otherwise any reduction in their cash reserves through open
market operations may be neutralized by the direct borrowing from
the central bank and the purpose will be defeated.
(g)
More Successful as Anti-inflationary Measure. The policy of

the open market operations is more successful as an antiinflationary measure rather than an anti-deflationary measure.
When the central bank sells the securities in the market and
reduces cash reserves of the commercial banks and thereby, the
banks cannot create credit if borrowers are unwilling to borrow
funds from the banks. During the period of depression, banks can
138
expand credit only when borrowers are willing to borrow. Thus, it

is an anti-inflationary measure.
3. Variable Cash Reserve Ratio.
The method of variables
reserve system was first suggested by Keynes, as a credit

control technique. Under this system, the commercial banks of
the country are required to maintain a reserve with the central
bank equal to a fixed percentage of their deposits. This is
known as the statutory maximum reserve. The theory of
variable cash reserve with the central bank will affect the
excess cash reserve with the commercial bank which is used in
credit creation. If variable cash reserve ratio is raised by the
central bank, the commercial banks can create credit only for a
small, value because their cash reserves are now small. If, on
the other hand, the central bank desires to raise the credit
volume in the economy, it reduces the ratio so as to leave the
higher volume of cash reserve to issue more credit.
For example,
Suppose, the central bank fixes 5% of banks deposits as minimum reserve ratio, it
means 95% deposit are with the commercial banks to raise credits. But suppose, the
central bank raises this limit to 7%, it means only 93% deposits would be available with
them for credit creation. If the ratio is lowered down to 4%, it would leave 96% of
deposits with the banks. The central bank may fix different rates of minimum cash
reserves to be maintained by commercial banks on different types of deposits.
This method of credit control is more direct and can achieve more prompt results than the
methods of bank-rate or open market operations. The central bank can increase or
decrease the cash reserve ratio thus contracting or expanding their lending capacity,
taking the need of credit in the economy.
139
Limitations of Cash Reserve Ratio.

(i)
The effectiveness of the method is limited in such circumstances when

commercial bank possess excessive reserve sufficient to offset any change
in the cash reserve ratio because the change would not affect their credit
creation power.
(ii)
Under depressed business conditions, lowering of the ratio could not be of

much help in expanding credit because the customer in such circumstances
would not be willing to borrow money from banks.
(iii)
This method is discriminatory against small commercial banks, not

possessing big cash reserve. The increase in cash reserve ratio will not
affect the credit creation power of bigger banks as they have large
excessive cash reserves. On the other hand, smaller banks excessive cash
reserves will be further reduced by the increase in cash reserve ratio. Thus
smaller banks will be hard hit by such operation of the central bank.
(iv)
The method creates a lot of uncertainty for the commercial banks and
limits their freedom to lend their resources to customers. They are always
under the constant fear of a sudden increase in reserve ratio by the central
bank.
(v)
It imposes a financial burden on the commercial bank as the central bank

does not pay any interest on cash reserves kept by it.
(vi)
The method is inflexible enough to remove the contraction or overflow of

credit in a particular region. The reserve ratio is the same for all banks in
all regions. This limitation, however, can be removed by classifying the
banks area-wise and fixing different cash reserve ratios for different areas.
11.11.3
Qualitative or Selective Methods of Credit Control
Qualitative or selective credit control methods are designed to affect the flow of credit in
specific or selective uses. The principal qualitative methods of credit control are:
i.
Margin Requirements on Secured Loans.
The commercial banks
generally lend funds to the borrowers on some securities offered by

borrowers and acceptable to banks. A commercial bank generally does
not lend upto the full value of security offered by the borrower but only a
140
part of the value of security is lent. The difference between the market
value of security offered and the value of amount lent is called margin
requirements, different margins against specific securities are fixed by
the central bank and are very frequently changed to regulate the flow of
credit.
Example,
Suppose, the central bank prescribes a margin of 40 percent against the security of food
gains; the commercial banks now can lend the money only upto 60 percent of the marketvalue of food grains. If the margin requirement is raised by the central bank to 50
percent, now the bank can offer only 50 percent credits against the securities foodgrains.
If it is reduced to 30 percent, 70 percent of the market value of foodgrains can now be
lent. Thus change in margin requirement changes the credit flow in the economy.
This method of credit control is generally used by the central bank to counter inflationary
pressures in the economy and just to counter speculative tendencies.
2.
Credit Rationing
Rationing of credit means the fixation of maximum limit or a ceiling on loan and
advances given by a bank and also in certain cases, a ceiling for specific
categories of loans and advances. If ceiling is fixed with reference to the total
amount of loans to be given, it is a quantitative method of credit control. But, if
ceiling is fixed with reference to specific types of credit, it is a selective or
qualitative credit control method.
Rationing of credit may assume any of the following two forms:
(i)
Variable portfolio ceilings, and
(ii)
Variable capital assets ratio.
(i)
Variable portfolio ceilings. Refer to a system by which the central bank

fixes a maximum limit for advancing loans for every commercial bank.
Under this system, no bank will be permitted to allow credit more than the
limit fixed by the central bank.
141
(ii)
Variable capital asset ratio. Refers to the system by which the central
bank fixes the ratio which the capital of the bank should have to the total
assets of the bank.
One more form of retaining of credit is fixing the limit of financial

accommodation to the commercial banks by the Central Bank either by means of
limiting the rediscount facility or fixing the 9 quota of every afflicted bank for
financial accommodation. This form is not a very popular form because, it goes
against the Central Banks function of the lender of the last resort.
Rationing of credit is, however, not a very popular method of credit control. It is
not a durable or long-term measure. It is only a temporary measure adopted by
the central bank in a planned economy, in as much as it helps to divert financial
resources into the channels fixed by the planning authorities or an abnormal
measure dictated by special circumstances.
3.
Regulation of Consumer Credit. Another method of selective credit control is

regulation of consumer credit. As is well known that the producers of durable
consumer goods such as refrigerators, televisions, motor vehicles, scooters,
washing machines etc. Offer these goods to consumers on loan or hire purchase
basis. The amount of loan under such a system is realized in instalments spread
over a period of time. The consumer at the time of purchase pays a part of the
total purchase price as down payment and the balance is financed by the bank
payable by the consumer in a fixed number of instalments. Larger the number of
instalments, easier would it be to the consumers to borrow and purchase such
durable consumer items. The central bank regulates such flow of credit for
consumer durable goods in two forms:
(a)
regulating the total volume of credit to be given by the commercial bank

to purchase a specific durable goods; and
(b)
Regulating the number of instalments in which the credit is to be paid.
The objective of this method is to curb the consumption of consumer goods which
happen to be in short supply or to increase the consumption of such items. It is
142
generally an anti-inflationary measure. This method is being used by the Central

Bank in many countries of the world.
4.
Control through directives. Sometimes the central bank enforces the selective
credit control by issuing directives to the commercial banks. The directives may
be in the form of written order, appeals or warming, in order to realize the
following objectives (i) to control the lending policies of commercial banks, (ii) to
divert credit from the less urgent or productive areas to the more urgent or
productive areas; (iii) to prohibit lending for certain specific purposes, and (iv) to
fix limit of credit for certain purposes. The commercial banks generally abide by
these directives issued by the central bank from time to time.
5.
Moral Suasion.
Under this method, the central bank advises, requests or
persuades the commercial banks to cooperative with the central bank in

implementing its credit policies. In case, the commercial banks do not follow the
Banks advice or request, no punitive active is initiated by the central bank. The
central bank uses its moral influence over the commercial bank in an endeavour to
get its policies accepted and it generally succeeds in its endeavour being in its
capacity as a lender of the last resort. The success of this method depends upon a
number of factors like (a) technical means and statutory powers of the central
bank; (b) degree of cooperation between the central bank and the commercial
banks; and (c) countrys banking and credit structure.
The method has its limitations too. The main drawback of this method is that it
lacks legal sanctions. As such, it fails to be effective at a time when inflationary
pressure and credit expansion forces are very strong in the economy.
6.
Publicity. Several central banks use publicity as a method of credit. Very

often, the central bank pursues the policy of publicity to make known to the
public the views about the credit expansion or contraction. It influences the credit
policies of the commercial bank and also educates and influences public opinion
in the country. It issues warning to the people and commercial banks, explaining
143
what is good or bad in the credit system of the country, substantiating its view by
facts, figures and statements through the media of publicity.
This method,
however, is not much effective in developing economies due mass illiteracy.
7.
Direct Action. Commercial banks that do not follow the credit guidelines of
central bank issued from time to time are generally subjected to direct action. It
implies the use of coercive methods against the erring commercial banks who fail
to carry out the credit control policies of the central bank. Direct action may take
any or more of the following forms:
i.
The central bank may refuse all together to grant re-discounting facilities to such
banks;
ii.
The central bank may refuse further financial accommodations to such banks
whose total borrowings have exceeded their capital and reserves.
iii.
It may charge penal interest on borrowings beyond the specified limit.
iv.
It may impose or alter the conditions for re-discounting.
The success of the direct action depends upon the commanding statutory powers of the
central bank in its relations with the commercial banks and its control on money market.
The direct action method should be used very cautiously taking into account the
following limitations:
(a)
It involves the use of coercion against the erring commercial banks. It

creates an adverse psychological reaction on commercial banks against the
central bank, that produces a direct confrontation between the central bank
and the commercial banks. No effective co-operation can be realized in
the wake of the fear of direct action.
(b)
This method involves many difficulties for the commercial banks. For
example, there is no clear cut distinction between essential and nonessential use of credit, productive and unproductive activities, investment
and speculation. There is again a difficulty of controlling the ultimate use
of credit by second, third or fourth parties.
(c)
The method is very much against the function of the central bank as a
lender of the last resort. In its capacity as a lender of the last resort, the
144
central bank cannot refuse to extend financial accommodation when

approached by a commercial bank.
Thus the Central Bank controls the credit expansion and contraction in the
economy by use of one or more of the above credit control measures taking the
various features of the economy.
11.11.4 Limitations of Qualitative Credit Controls
These methods apply only to banking institutions. Non-banking institutions which create
a sizeable portion of total credit in the economy are outside their scope. The central bank
has no control over such institutions.
1. Because the main purpose of selective credit control is to divert the flow of credit
from non-essential and non-productive uses to essential and productive uses, but it
is very difficult to make a clear cut distinction between essential and nonessential or productive and non-productive uses of credit.
2. Sometimes the borrowers take loans from commercial bank banks for authorized
purposes but later on these loans are advanced to some other person for other
purposes. It is very difficult for commercial bank to control the ultimate use of the
credit in the economy by second, third or fourth users.
3. It is also possible that commercial banks themselves may advance loans to their
customers for prohibited users under various guises through manipulation of
accounts. This practice makes the selective credit control ineffective.
145
11.11.5 Learning Activity

Differentiate between;
(i) Variable portfolio ceilings and
Variable capital assets ratio,
Explain why Open Market Operations is considered to be more suitable as antiinflationary tool,
List and explain the methods of Quantitative credit control,

Explain how loans make deposits. What are the limitations to such credit
creation by banks,
Discuss the significance of bank rate as a tool in the hands of the central bank,
In your own view, suggest a suitable credit control technique for a developing
country like Kenya, give reasons to support your answer,

The student can read further on money and banking
11.11.7 Summary
In summary we have learnt that;
LECTURE EIGHT: TAXATION OF PARTNERSHIP & COMPANIES
There are two methods of credit control, namely; Qualitative and Quantitative,
The methods of credit control apply only to banking institutions. Non banking institutions
which create a sizeable portion of total credit in the economy are outside their scope,
146
12.0 LECTURE TWELVE: BANKING SYSTEM
12.1 Introduction
Central bank is the spex bank in the country. It is called by different names in different
countries. It is the Reserve Bank of India, The Bank of England in England, The Federal
reserve System in America,, The Bank of France in France etc.
Central Bank is basically different from a commercial bank. The central Bank does not
engage itself in ordinary banking activities like accepting deposits and advancing loans to
the public. It does not aim at making profits like the commercial banks. Rather, it aims at
controlling the commercial banks and implementing the economic policies of the
government. The central bank is generally owned by the government and managed by the
government officials or those who are connected with the government. About the
commercial banks are pawned by the shareholders like any joint stock company. Lastly,
every country has only one central bank with few branches across the country. On the
other hand, there are many commercial banks with hundreds of branches and agencies
inside and outside the country.
12.3 Specific Objective

By the end of this lecture the student should be able to:
State the changing role of Central Bank
Intermediary function of commercial banks
Differentiate between money and capital market
Economic role of non-banking financial institution.

12.12 .1 Definition
12.12.2 Role of Central Bank of Kenya
147
12.12.3 Money and Capital market

12.12.4 Role of Financial Intermediaries
12.12.5 Non-Banking Financial intermediaries
12.12.1 Definition of a Central Bank

A central Bank has been defined in terms of its functions. According to Vera Smith, the
primary definition of central bank is a banking system in which a single bank has either a
complete control or a residuary monopoly of note issue.
Sayers defines a central bank as the organ of the government that undertakes the major
financial operations of the government and by its conduct of these operations, and by
other means, influence the behaviour of financial institutions so as to support the
economic policy of the government.
Finally, De Kock defines a central bank as the bank which constitute the apex of the
monetary banking structure of its country and which performs as best as it can in the
national economic interest.
12.12.2 The role of central banks
(i)
Central banks generally formulate and implement the monetary policy in a given
country. This function is usually directed to achieving and maintaining price
stability. In this regard Central banks have sometimes issued guidelines on credit
and interest rates. In addition, they have often been agencies of governments for
issuing and underwriting of government borrowing instruments such as treasury
bills. They, therefore, play a vital role in controlling the level of money supply in
a given country.
(ii)
Central banks have a role of encouraging liquidity, solvency and proper

functioning of the financial system.
Central banks thus sometimes inspect
commercial banks and other financial institutions and in this way become
principal advisors on whether or not to issue or renew licences of financial
institutions. In addition, authorized dealers in the banking markets are usually
supervised by the central bank.
(iii)
Central banks usually formulate and implement a countrys foreign exchange

policy.
In countries that have exchange control, the central bank may be
responsible for enforcing such controls. A related aspect is the management of a

148
countrys foreign exchange reserves which is usually conducted by the Central

Bank.
(iv)
Central banks also usually act as banks, advisers and fiscal agents of the
government.
(v)
Central banks issue currency notes and coins in their respective countries. In this
regard they often took over from currency boards which originally had the
function of issuing currencies.
12.12.3 Central Banks changing role

The role of the central banks in economic management has gradually changed.
Transition is however far from complete in the sub-Saharan Africa.
In most countries, developed and developing alike, the role of central banks has been
narrowed to that of ensuring price stability. This implies aiming to realize economic
growth without generating inflation.
In countries like Kenya, Uganda and Tanzania, the Central Bank Acts have been
amended to make the banks autonomous in their operations with their objectives
narrowed to only two, namely to:
Ensure price stability by having full control on the supply of money; and
Ensure that the banking system and by extension the financial system as a whole
is stable and conducive to promotion of savings and investment.
In pursuit of these objectives. The banks rely on the power of market forces.
The price stability objective can hardly be achieved in a situation where instability
prevails in the banking industry. Accordingly, where a separate supervisory authority is
not in place, the central banks assume the task of ensuring that deposit-taking institutions
do not undermine stability in the banking industry:
(i)
The central banks playing this role have to ensure that deposit-taking institutions
are not under-capitalized.
(ii)
The banks have to be satisfied that banking institutions make adequate provisions
for bad and doubtful debts.
149
(iii)
The banks also have to be satisfied that banking institutions avoid credit
concentration to one borrower. This implies diversification of loan portfolios is
vital for good banking business.
(iv)
Central banks have to be satisfied that business is conducted in premises with

adequate security arrangements and by personnel who, in the opinion of central
banks, are qualified to carry out banking business.
12.12.4 Money and Capital Markets

Financial markets refer to all trades that result in the creation of financial assets and
financial liabilities. They are concerned with the relationship that subsists between the
suppliers and demanders of funds, including the intermediate institutions which are the
demanders and suppliers of funds. The three types of financial markets are the money
market, the capital markets and the foreign exchange market. The foreign exchange
market will be covered in the chapter on international trade and finance.
The money market: The money market is the financial market segment that deals in
very short term overnight to six months funds. Banking institutions are the key players in
the money market. The market segments of the money market in Kenya include the
interbank market, the government securities market and private securities like
commercial paper, certificate of deposit and bills of exchange.
Money market
participants in Kenya include the government, the central bank, the supervisory authority,
50 commercial banks, 21 non-bank financial institutions, building societies, insurance
companies and entities. The role of the money market in the economy is as follows:
(i)
It mobilizes short-term funds to support economic activities by the government

and the private sector.
(ii)
It is a medium for the central bank monetary policy such as managing the banking
system liquid influencing short term interest rates, controlling inflation and
influencing developments in the exchange rate.
(iii)
The money market provides a medium for commercial banks to manage their
funds by allowing them to lend temporary surplus funds and borrow funds to
support their lending commitments.
150
12.12.5 The role of financial intermediaries

Financial intermediaries are organizations, which channel funds from institutions and
individuals who have financial surpluses to institutions and individuals which wish to
borrow funds. They therefore intermediate between lenders and borrowers, earning their
profits from the difference in the rate of interest paid to depositors and the rate of interest
charged to borrowers. The main financial intermediaries in the Kenya economy are
commercial banks, insurance companies and building societies, unit trusts, pension funds,
and others. Disintermediation describes the bypassing of financial intermediaries so that
borrowers and lenders deal with each other with the possibility that costs can be saved.
12.12.6 The functions of commercial banks

The following are the functions of commercial banks in an economy:
(i)
Commercial banks provide a payment mechanism through which individuals,

firms and government can make payments to each other. Modern banks utilize a
payments clearing system which enables individuals and firms to make payments
by cheque. Commercial banks also constitute a source from which individuals
and firms can obtain notes and coins.
(ii)
Commercial banks also provide a place for individuals, firms and government to
store their wealth, for example, in the form of current or deposit accounts.
Commercial banks also compete in order to attract funds from different
individuals and organizations.
(iii)
Commercial banks lend money in the form of loans or overdrafts. They charge an
interest on such loans from which they generate a substantial proportion of their
incomes.
(iv)
Commercial banks act as financial intermediaries by accepting deposits and

lending to individuals and organizations that require finances.
(v)
Commercial banks also act as foreign exchange dealers. They provide a means of
obtaining foreign currencies or selling foreign currencies. They make their profits
on the basis of the spread which is the difference between the buying and the
selling price of the foreign currencies.
151
(vi)
Commercial banks may also provide their clients with expert advice on a broad
range of matters such as those relating to investment, takeover bids, share
registration and leasing.
12.12.6 The role of non-bank financial intermediaries in the Kenyan economy is as

follows:
(i)
They stimulate competition with commercial banks over deposits and over the
credit market, which stimulates efficiency in terms of improved services for
savers and borrowers in the financial market.
(ii)
They have enhanced the development of the financial market through the
introduction of a great variety of financial instruments. Thus, for example,
deposits such as investment deposits accounts, mortgage deposit accounts,
savings and credit union members contribution accounts, building societies
members accounts feature in the financial market.
A greater variety of
financial instruments is desirable for the development of financial markets in

order to cater for differences in savers and borrowers interests.
(iii)
Commercial banks traditionally lend out funds on a short-term basis to safe

borrowers and thus do not effectively cater for long term risky borrower
market whereas non-bank financial intermediaries often lend out on longerterm basis and to risky areas, which explains why, they often charge high rates
of interest than commercial banks.
(iv)
Non-bank financial intermediaries often provide financial services which are

beyond the scope of commercial banks such as chattel mortgage loans and
purchase finance.
(v)
The development of non-bank financial intermediaries through its expansion

of the financial markets has created an additional vehicle for the more
effective execution of the governments monetary policy.
The major differences between commercial banks and non-bank financial institutions
are as follows:
152
(i)
Commercial banks operate cheque accounts, which make them members of

the central bank clearing houses whereas non-bank financial institutions are
not members of the central bank clearing houses since they do not operate
cheque accounts.
(ii)
Commercial banks can create credit by allowing cheques to be drawn on them

in excess of the amounts deposited with them whereas non-bank financial
institutions merely transmit funds that have been deposited with them.
(iii)
Commercial banks usually accept short term deposits and lend on short term,
relatively secure whereas non-bank financial intermediaries may accept long
term deposits and lend on relatively long term and more risky ventures which
enables them to charge higher interest rates.
(iv)
Commercial banks operate bank accounts with the central bank, which is the
bankers bank whereas non-bank intermediaries do not have this facility.
(v)
Some deposits placed with commercial banks, notably current account

deposits, are non-interest bearing whereas all deposits placed with non-bank
financial intermediaries are interest bearing.
153

1. Assess the role of Central Bank of Kenya,
2. Differentiate between the non-banking financial institution and commercial banks,
3. Explain how the central bank ensures stability of commercial banks,
4. Differentiate between money market and capital market,
12.12.8 Self-Test questions
Notes:
Critically assess the development and contribution of commercial banks in Kenyan
economy
since independence,
Discuss the challenges experienced by the Central Bank of Kenya in discharging

its duty in the economy,
Explain the role of non-banking financial institution in developing countries,
Account for the recent shift from conventional quantitative control to qualitative
control,
12.12.9 Summary
In this lecture we have learnt:
Central Bank is the apex bank of a country,
Performance and development of an economy is influenced by the central bank,
Activities of the commercial banks are directly controlled and regulated by the central
bank,

The students can read further on the changing roles of the central bank,
154

CFM 302. Monetray Theory Policy

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CFM 302: MONETARY THEORY AND POLICY

CFM 302: MONETARY THEORY & POLICY

CFM 302: MONETARY THEORY & POLICY

BUSS 101/CFU 102 : INTRODUCTION TO MICRO-ECONOMICS

About this STUDY MANUAL

How this STUDY MANUAL is structured

CFM 302: MONETARY THEORY & POLICY

An introduction to the CHAPTER content.

BUSS 101/CFU 102 : INTRODUCTION TO MICRO-ECONOMICS

MODULE TITLE: CFM 302-F MONETARY THEORY AND POLICY

CFM 302: MONETARY THEORY & POLICY

Qualities of a good money................................................................................6

Role of money in different economic systems..................................................8

Summary of the lesson.....................................................................................9

1.1.10 Further Readings..............................................................................................9

Demand for Money........................................................................................11

Transactional Demand for money..................................................................12

Keynesian approach to the Demand for money............................15

Supply of Money .........................................................................16

BUSS 101/CFU 102 : INTRODUCTION TO MICRO-ECONOMICS

Components of Money supply.......................................................18

Items excluded in the money supply..............................................18

Determinants of money supply......................................................20

2.2.10 Lecture activities............................................................................23

CFM 302: MONETARY THEORY & POLICY

5.0 LECTURE FIVE : KEYNESIAN VIEWPOINT ON THE QUANTITY THEORY OF

BUSS 101/CFU 102 : INTRODUCTION TO MICRO-ECONOMICS

CFM 302: MONETARY THEORY & POLICY

BUSS 101/CFU 102 : INTRODUCTION TO MICRO-ECONOMICS

1.0 LECTURE 1: INTRODUCTION TO MONETARY THEORY AND POLICY

1.1.1 Specific Objectives

Explain the various evolutionary stages of money.

Identify the qualities of a good money

Outline the role of money in different economic systems

1.1 Lecture Outline

CFM 302: MONETARY THEORY & POLICY

1.1.2 Evolution of money

BUSS 101/CFU 102 : INTRODUCTION TO MICRO-ECONOMICS

confidence in them. As 1st time bank notes/receipts were not considered as

1.1.3. Functions of Money

money. It is easy to compare the relative values of commodities which are

CFM 302: MONETARY THEORY & POLICY

dissimilar and entirely different from one another.

The values are in

proportion to their respective prices.

transactions. It makes borrowing and lending less risky by acting as standard

1.1.4 Qualities/properties /characteristics of good money

BUSS 101/CFU 102 : INTRODUCTION TO MICRO-ECONOMICS

5. Homogeneity: For money to act as unit of account different units of money

Consumer can make a rational choice of goods.

Production decisions are based on money

Money simplifies the distribution system

Decision regarding saving and spending

Price mechanism regulates the flow of investment

CFM 302: MONETARY THEORY & POLICY

Money is the basis of credit

Is a guide to economic activities

BUSS 101/CFU 102 : INTRODUCTION TO MICRO-ECONOMICS

1.1.6 Lecture Activities

Identify the core qualities of a good money

1.1.7 Self Test Questions

Explain why money is considered to be more important in a capitalist than a

Money can move immovable property